Baxter Wasson Rodrigo Trelles

Nonetheless, Baxter Wasson and Rodrigo Trelles, co-heads of O’Connor Capital Solutions, see compelling opportunities for making smaller loans in the non-sponsor/smaller sponsor-backed part of the market.

As banks steadily recede from the loan market, private credit funds have proliferated both in number and scale to cater for unmet borrowing demand. However, amid the deluge of capital flooding into private credit, some investors are scrutinizing whether key supply-demand dynamics are sustainable.

Citing Preqin data, a recent article Number of global private debt funds hits new record by Benefits and Pension Monitor stated “There is now a record number of private debt funds, growing by 19% from 2022 to 1,080 at the end of Q3 2023, with over 40% increase in the capital being targeted by new funds.”1 In terms of scale, Preqin’s Future of Alternatives 2028 report forecasts that private credit will nearly double in size and reach USD 2.8 trillion by the end of 2028.2 And while data from Preqin implies private debt fundraising last year was relatively flat when compared to 2022, this could represent a mere bump in the road as levels are still quite strong relative to other alternative asset classes.3

In spite of (or perhaps ‘because of’) higher interest rates, this systemic departure from banks and bank-arranged deals appears set to persist. Many borrowers clearly value the expediency, certainty, and direct engagement facilitated by private credit lenders, which often leads to a superior borrowing experience compared to traditional banks or public markets. This could help explain why even borrowers historically reliant on the leveraged loan or high-yield bond markets have been drawn to private credit in recent years.

The ascendance of private equity sponsors and the exponential expansion of the ultra-high net worth individual (USD 20+ million)/family office segment are also notable contributors to the burgeoning demand as both possess a wide array of enterprises and assets that require financing.

Healthy dry powder levels suggest competition for markets share will continue

Source: Pitchbook 4Q22, October 2023

Column chart showing dry powder direct lending AUM and unrealized value from 2006 to 2022 suggesting competition for market share will continue.

The allure of smaller scale?

Not all private credit funds are created equal. The asset class encompasses diverse sub-strategies, each with distinct dynamics.

The upper segment of middle-market lending has evolved into a distinct asset class dominated by a growing number of private credit managers, primarily focusing on underwriting substantially sized loans (ranging from USD 500 million to USD 2+ billion) to large enterprises generally owned by prominent private equity sponsors. As referenced earlier, the majority of fundraising within this segment has accounted for a significant portion of the recent capital raised in private credit. Preqin data supports this, showing that private debt investors are allocating capital to a small number of larger funds.4

While attention has predominantly focused on upper-middle-market direct lending, lesser-known sub-strategies and segments warrant consideration as a supply and demand mismatch persists in these parts of the market. Other strategies include: the non-sponsor-backed lending; asset-backed lending (which may involve financial assets and/or hard assets as collateral); mezzanine lending special situations or hybrid opportunities and distressed investing).

Historically, lending to the non-sponsor backed market was conducted by regional and mid-size banks; however their capacity to serve these segments has diminished due to regulatory constraints and internal strains. As the latest Senior Loan Officer Opinion Survey on Bank Lending Practices highlighted, “regarding loans to businesses, survey respondents, on balance, reported tighter standards and weaker demand for commercial and industrial (C&I) loans to firms of all sizes over the fourth quarter.”5

Notably, sourcing opportunities in the non-sponsor backed part of the market poses challenges due to the large number of potential borrowers who own and operate middle-market businesses that do not have “capital markets” desks. This ecosystem typically generates deal flow characterized by smaller, relatively complicated loans (USD 25 million to USD 250 million) to help them find (and negotiate with) lenders. This requires disciplined underwriting and structuring tailored to the specific company or assets being financed. This presents a significant opportunity as small to mid-sized US companies significantly outnumber their large sponsor-owned counterparts, creating persistent need despite limited non-bank/private credit lender supply.

Implications for investors

While data on this portion of the market is relatively scant, data is starting to show that the combination of these factors – i.e., non-sponsor/smaller sponsor loans – allows for higher pricing, lower leverage and more lender-friendly covenants.6

It is therefore possible for investors to diversify their private credit portfolios by incorporating such exposure; returns are typically uncorrelated with other credit holdings and exhibit diminished sensitivity to interest rate fluctuations.

However, few private credit managers can deliver this as doing so generally requires access to proprietary and well-established sourcing networks capable of facilitating steady deal inquiries across diverse borrower profiles, loan structures, and collateral types – an example of where being affiliated with a global bank and wealth manager can be a notable advantage. The handful of managers that can offer this may be able to exploit the scarcity premium on offer by providing tailored borrowing solutions in markets with limited lending competition.


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