Private credit: reaching new frontiers
31/07/2024From increasing democratisation to a decreasing reliance on private equity sponsors, H/Advisors’ alternatives specialist, Finlay Donaldson, explores the key trends driving the growth of private credit – a now huge asset class swallowing up lending opportunities previously dominated by the banking system.
A report from Preqin [1] earlier this year predicted that the size of the private credit market is now nearly $1.5 trillion in assets under management, with some estimates predicting it is closer to $2 trillion. This compares to a market size of just $315 billion in 2010 following the global financial crisis (GFC).
Whatever the number now, it is obvious that private credit has been one of the main beneficiaries since the GFC, and in the wake of several other market dislocations since, most notably the coronavirus pandemic and the fallout from the Russo-Ukrainian war.
What kick-started the boom in private credit?
In short, regulation, but also the long period of low interest rates driving growing investor allocations into alternatives in the great hunt for yield. The “retrenchment” or withdrawal of banks from riskier forms of lending post GFC and, in some cases, even from those parts of the market that would previously be deemed their bread and butter. The need for banks to keep regulatory capital on balance sheets and therefore take fewer risks with defaults is largely to blame for this. Enter the private credit firms to fill the void. Meanwhile the banks were largely content (although the sentiment is now changing as private credit expands) with their continued dominance in lower risk areas such as investment grade corporate subscription lines.
While some experts predict that there could be a moment of reckoning on the horizon for some private credit players, most would agree that market dynamics and increasing investor appetite mean that further growth is on the cards in the short and medium-term. Moreover, much of the lending business the more high-profile private credit providers have picked up is investment grade.
Here are some of the other key features underpinning the private credit space.
- Democratisation – many alternative asset classes, including real estate and private equity, have already been forced to turn to “wealth” or retail investor capital in the wake of allocation limits being reached by institutional investors. Private debt is now doing the same, creating semi-liquid fund structures for wealth and retail investors across Europe.
Investment trusts in the UK and fund structures like ELTIFs are the best examples of the vehicles with which alternative asset managers have been targeting retail money, but these funds do raise the question of whether increased liquidity in these asset classes is a good thing or harms the way in which returns are generated. The so-called “illiquidity premium”.
It’s worth remembering that retail investors have also been hungry to get more direct access to the superior yield opportunities available from private capital – and private credit is the hottest trend with its own risk/reward dynamics (different from say buyout or infrastructure). So the stars are aligned to bring private credit to the masses.
- Sponsorless – as private equity M&A activity has decreased in recent years as the macro economic environment changed (with the caveat it is slowly returning now based on leverage loan data), more companies – now more familiar with private capital as it’s grown – have increasingly explored the possibility of debt rather than equity transactions, without the presence of PE owners.
Some private debt funds are now allocating as much as 50% of a fund’s capital to this type of transaction, although it does require excellent origination skills and trusted relationships with company founders and owners, as many private debt players do not actually want to be handed the keys to the operation – that would be better suited to more traditional buyout fund.
- Secondaries growth – while still a relatively nascent market outside of the most established firms like Apollo and Pantheon, some investors see private debt secondaries as the next big growth opportunity.
In a recent interview [2], Pantheon suggested that it was seeing nearly 10 times as much deal flow for private debt secondaries compared to 5 or 10 years ago. So the runway is clearly lengthening for this asset class. However, although without quite the market opportunity of private equity secondaries, largely down to the lifespan of the investments. Debt tends to be refinanced quicker than buyout firms sell on their assets.
- Expanding the toolbox with private debt niches – markets like direct lending and real estate debt are well-established, but more niche asset classes (arguably now mainstream) like NAV lending (established by 17Capital in the wake of the GFC to provide a broader portfolio management toolkit) have experienced phenomenal growth. These are viewed by LPs as an excellent way of diversifying a portfolio away from lower returning senior debt direct lending funds. They also give GP managers better options to optimise their whole fund portfolio, as well as access to finance for their own growth as a firm (perhaps expanding into a new market or buying another manager).
- Tying the knot – partnerships are becoming more frequent between private credit funds and other financial institutions, including insurance groups, sovereign wealth and even high street banks, as was the case earlier this month with the tie-up between Lloyds Banking Group and Oaktree.
The life insurance permanent capital investment model was the brainchild of Marc Rowan and team at Apollo, which subsequently merged with insurer Athene. But all these tie-ups are seen as viable ways of accessing more evergreen capital or permanent capital (reducing the need to rely on fundraising in the more traditional sense). In the case of the banks and sovereign wealth, it’s a relatively safe way of penetrating an increasingly saturated market with the investment management capabilities of an established name. So far from being rivals, banks and private capital providers are more partners.
While these are by no means the only drivers behind private credit, they go a long way to explaining the exponential growth of the market we’ve seen in recent years. There are sure to be headwinds, namely regulatory intervention in this and other alternative asset classes, but their importance in fuelling the real economy globally – where capital is sorely needed – is well established. So if I was a betting man, I would bet on us seeing more of their role in fueling companies and economies, than less.
[2] https://www.pionline.com/alternatives/private-credits-rapid-growth-spilling-over-secondaries