Why are we talking about this again?
By now, virtually everyone has heard about it – including their proverbial grandmother.
Advisors are calling, friends are flossing about what fantastic fund their advisor got them into.
If you haven’t been keeping track of the meteoric rise of private credit and its workings – this is for you.
First, the bigger picture
Since the pandemic, private credit has been growing at a break-neck pace of c20% annually, stepping out from its bigger brother’s shadow, private equity.
While this makes private credit the fastest-growing segment in the investment/asset management industry, it is still relatively small, making up approximately 0.7% of the total global financial markets.
Fine, I bite – So, what exactly is Private Credit again?
Private credit is simply lending to private companies by ‘non-banks’. In essence, it’s private investment funds lending money from sources such as pensions, insurance companies, and even retail investors – to larger SMEs, typically those with less-than-stellar credit quality.
For example – imagine a mid-sized cybersecurity SaaS company wanting to buy a smaller competitor for $10 million. Back in the day, the CFO would call its main banks and ask for a loan. The bank might approve that loan (from its own balance sheet) – or not. But in either case, there weren’t many other options.
After the 2008 financial crisis however, banks became more risk-averse due to stricter regulations and often rejected the CFO. This opened the door for private investment funds, that quickly stepped in to fill the gap (along with Broadly Syndicated Loans market). These funds ended up becoming essential to whole corporate lending ecosystem – especially for ‘historically less eligible’ companies with credit ratings of BB or lower.
So, today that CFO will not only sit down with the banks, but also with private investment firms like Oaktree Capital, Ares or Owl Capital to hash out a private credit deal. And most likely this will be a floating rate, typically SOFR (Secured Overnight Financing Rate) plus a few percentage points.
Why do Borrowers like it?
Now, actually raising private credit is often pricier than issuing debt/bonds to the public markets. But given the size and creditworthiness of the companies, that’s often neither in the cards, nor desired given all the requirements that also come with it.
Private credit deals instead tend to –
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get done quickly these days (all that raised capital needs to be put to work…)
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offer the company pricing certainty, often dealing with only one counterparty
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allow for extensive customization options around e.g., duration, collateral, potential equity participation, or PIKing*)
*Payment-In-Kind (PIK) allows a company to repay their debt with additional debt instead of cash (i.e., interest accruing onto the principal balance)
Why do Investors like Private Credit?
Probably, first and foremost: Returns. With interest rates at their highest in more than a decade, yields in private credit have become more attractive (they tend to be almost exclusively floating rate).
Then, there is some built-in security from the debt’s privileged position in the capital structure – meaning you are among the first to get paid if things go south.
And then, there are the (perceived?) evergreen arguments for private over publicly traded assets – significantly lower market volatility and valuation uncertainty.
Ok – so what’s News in the Private Markets and Debt space?
The pace of new money flowing into private markets as a whole has slowed down over the past years.
But, while some lights may be dimmed… private credit is still the life of the party.
About 12% less capital has been deployed into credit funds throughout 2023 vs. prior year. However, the rest of private markets (e.g. PE and real estate) have seen declines that are twice as steep.
Why – What’s happening here?
There are many factors in play, with one crucial yet often overlooked driver is:
–The Numerator Effect-, or ‘What keeps Private Market Fundraisers awake at night’
Imagine a pension fund with a $10 billion portfolio, aiming for 10% ($1 billion) in private markets. If public market assets fall by 20%, the portfolio drops to $8 billion. Now, that $1 billion in private markets represents 12.5% of the portfolio, overshooting the target allocation. This forces the fund to pause new private market investments until the balance is restored.
And that’s what happened in 2023… many institutional investors found their private market allocations levels blowing way past their targets, due to a sharp decline in the value of their public market holdings in a challenging 2022. This drop reduced the overall portfolio value (the denominator) without a similar decline in private market holdings (the numerator)*.
There are of course other reasons why investors are less enthusiastic than just 2 years ago:
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The offer is less attractive in itself: (1) returns in private markets look less attractive -on paper- as revaluations from public markets are trickling down to private assets and (2) distributions (i.e. actual payouts by funds after things get sold, loans paid back, etc.) have decreased significantly or are behind expectations.
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There’s an actual alternative now: (3) higher interest rates mean that allocators no longer need to chase higher returns at any cost/risk, but can reduce their risk seeking assets and instead buy some ‘boring’ fixed income assets, that often also better match up with their (e.g. pension) liabilities.
With these headwinds, where to turn to next?
Enter: The Retail Investor
Retail** investors have hopped on the private markets band-wagon, and are now picking up some of the slack from Instituationals across credit and other classes.
For context, in 2022, only 9% of private credit funds had retail-focused offerings. However, 25% of these funds then said they intend to launch at least one such offering within the next five years.
Given the ubiquity of private credit ads via advisors, but also online and throughout any major cities, it does appear substantial progress has been made in that area…
…To be continued
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Next up in the series:
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Private Credit Unplugged (2/3): The Private Credit Maze – A retail investors’ perspective, and about finding the exit
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Private Credit Unplugged (3/3): The Credit Markets Go Dark – Key Insights from the Upcoming Yale Law Review Paper (and inspiration for this series)
*Now, at this point you might wonder why the pension’s private assets aren’t re-valued at a somewhat similar pace to their public market counterparts, especially if there are large/macro dislocations at the root cause? …eeh yes, that’s a big topic we’ll try to unpack in the following post.
**Asset managers/those funds usually define the term ‘Retail’ rather broadly and probably less flattering as your private banker. Essentially, unless you’re reading this while flying your helicopter from Nice Airport to your superyacht in Antibes – you’re probably ‘Retail’.
