Since the 2008 financial crisis, traditional banks have been squeezed by unprecedented capital and liquidity pressures. The regulatory changes brought about by accords such as Basel III have shrunk European bank lending by some $2 trillion—a contraction that has spurred companies to seek alternative funding sources beyond banks. Meanwhile, investors, aiming to diversify their portfolios to hedge against public market volatility, have nurtured a burgeoning private credit market that bridges corporate capital gaps and investors seeking new revenue.

Summary

• Private credit investments, which bypass traditional banking systems by directly lending to businesses or purchasing debt assets, have emerged in various forms—direct lending, mezzanine loans, second lien debt, preferred equity, distressed debt, and other special situations.
• Post-2007/2008, banks’ retrenchment from lending left many firms, particularly SMEs, scrambling for non-traditional funding, a void private credit has adeptly filled.
• Despite the initial slowdown due to 2022’s interest rate hikes, demand-side trends will likely continue propelling private credit growth.
• While private credit is predominantly North American or European, Asia is increasingly becoming the focal point due to its vast untapped financing needs.

What Is Private Credit?

Private Credit, as the name suggests, is an alternative lending avenue distinct from traditional bank loans. Compared to asset classes like private equity, private credit is a relative newcomer, having been started around 2010. Over a decade, it has burgeoned into a significant $1.5 trillion market.

Private credit's ascent has been fueled by direct loans to businesses and the purchase of debt assets, providing a detached route from conventional banking systems. Such direct loans often carry floating interest rates and require collateral from borrowers to mitigate credit risk, with a higher priority in bankruptcy proceedings.

The four common private credit types are:

1. Direct loans: Popular for their higher placement in a company’s capital structure and relatively lower risk, they are mainly extended to private, unrated firms.
2. Mezzanine, second lien debt, and preferred equity: Collectively known as 'junior capital,' these are forms of subordinated debt, offering additional leverage without collateral, ranking lower in repayment hierarchy in default or bankruptcy scenarios.
3. Distressed debt: Investors collaborate with financially troubled firms to improve operations and restructure balance sheets, typically linked to economic downturns and credit tightening.
4. Special situations: These involve highly customized and complex transactions, such as companies undergoing mergers, capital events, or asset sales.

The Mergers and Acquisition Market

In the low-interest-rate environment of the past decade, buoyed by equity market growth and a surge in private equity investments, global M&A activities peaked at nearly $6 trillion in 2021. Pre-crisis, bank or public debt markets financed most of these activities.

Statistics show a marked decrease in banks' participation in US mid-market financing, now estimated at around 10%, with a similar contraction in Europe. Thus, many private credit managers are now deeply embedded in M&A operations.

Why do firms turn to private credit?

Post-crisis, banks' substantial lending cuts propelled companies, especially SMEs, towards non-traditional credit sources. Private credit offers a non-conventional lending mode, typically extended by non-bank entities or individuals to private, non-investment-grade companies.

Despite the initial slowdown due to 2022’s interest rate hikes, demand-side trends will likely continue propelling private credit growth. Its advantages over traditional credit include:

• Certainty of execution: Private credit transactions bypass market syndication and rating processes, thus not subject to market volatility or credit issues.
• Flexibility and customization: Private credit does not overly restrict capital usage and can tailor to individual borrower needs.
• Long-term relationships: Fewer institutional holders of private credit facilitate easier loan agreement adjustments and cooperative relationships in adverse conditions.

Looking Ahead

While private credit is predominantly North American, Asia is increasingly becoming the focal point due to its vast untapped financing needs. From 2014 to 2022, Asia's private credit AUM doubled, yet its global market share has room to grow, not reflecting Asia's role in global economic expansion. Studies also indicate that 68% of Asian mid-sized firms deem non-traditional financing crucial, with 82% planning to seek such solutions within a year.

Rising interest rates and inflation exacerbate borrowers' financial pressures but also present opportunities and challenges for private credit investors: Rising rates bode well for private credit investors, as most loans are floating-rate instruments, meaning interest payments increase with rates.

However, private credit carries an illiquidity premium: compared to publicly traded (leveraged) loans, private loans (senior/secured debt) typically yield a 150 to 300 basis point premium. Distressed and subordinated debt command even higher premiums.

While private credit default data isn't directly accessible, leveraged loan default rates are observably lower than index data suggests, with higher recovery rates and thus lower loss rates.

Probability of private company defaults are influenced by GDP growth and inflation rates, with the latter posing a higher risk due to financial stress on highly leveraged firms, making it difficult to service debt.

Ideas and Suggestions

In investment portfolios, appropriate private credit investments can offer cash flow akin to traditional fixed income. Selecting the right targets can mitigate portfolio volatility due to private credit's lower correlation with public markets.

Successful private credit investments hinge on several key factors: the method of quantifying investment risks, effective risk pricing, and managing risk variations throughout the investment cycle. As lenders and investors, choosing defensive, non-cyclical businesses can mitigate inflationary pressures, reducing default risks.

Today, as private credit has become an important investment tool, investors can incorporate it into their portfolios as a potential high-yield alternative to traditional fixed-income strategies, with proper allocation and designated exposure of their needs.