Edoardo Rulli Baxter Wasson Kevin Lawi

The growth of the private credit market has been nothing short of breathtaking and, in just a few short years, interest has skyrocketed along with assets under management.

What was once a niche corner of the alternative investment landscape, private debt – in which credit is extended by non-bank lenders – has morphed into one of the success stories of financial markets, with assets predicted to jump to a hefty USD 3.5 trillion by 2028, according to data firm Preqin. 

 So how has this come about? Well, in short, the onset of the global financial crisis has been integral. While the 2008 economic crisis brought with it a litany of problems, it also created opportunities; the resultant retrenchment among traditional lenders, who had their own balance sheets to repair and new regulations to contend with, created a lending vacuum that non-bank players gladly filled.

Edoardo Rulli, chief investment officer, head of UBS Hedge Fund Solutions, puts it simply: “The growth story just continues,” he says. Baxter Wasson, Co-Head of O'Connor Capital Solutions, builds on this by adding: “In the wake of the GFC there was a pullback in lending by banks, and so a supply and demand imbalance emerged across the board, which became very favorable for new lenders. And that's what allowed them to create strong transactions with attractive pricing.”

Indeed, many indications point to the private debt market swelling at an even faster rate, especially considering the regional banking crisis in the US where Silicon Valley Bank hit severe problems and disappeared from the market almost overnight after US regulators were forced to take control of the West Coast lender. Rulli says the “disintermediation of banks shows no signs of slowing down” in the wake of SVB’s demise, with calls for banks to increase their capital ratios, providing an even greater footing for the private debt market.

And the numbers bear this out, with the assets of private credit funds spiking from just over USD 310 billion at the end of 2010 to an impressive USD 1.52 trillion today, according to the most recent figures from Preqin. To put this into further perspective, in 2000 the market consisted of just USD 44 billion of assets under management.

A particular draw of direct lending is it is a floating-rate asset that offers some protection from inflation and rising interest rates. However, with central banks across the world finally getting to grips with rising prices, the US Federal Reserve and the European Central Bank appear ready to start cutting rates – though exactly when this year remains a moving target.

A maturing middle market

But what of fears that some may be late to the party? Well, the first thing to say is that as private credit has matured and grown, so has its sub-segments.

Rulli argues that part of the market’s overall appeal is down to it being a relatively easy strategy to understand and explain to investors as it provides regular payments and offers important diversification. Crucially, it is also diversified from other alternatives by size, sector and the obtainable downside protection.

Indeed, drawn to its potential diversification benefits, investors are therefore now approaching their allocations with a “Core and Satellite” framework: “core” being “middle market direct lending” (that is, relatively large loans to companies that are owned private equity sponsors); and “satellite” encompassing a wide range of other private credit strategies.

“Core” opportunities

Referring to the upper middle market segment, Kevin Lawi (Managing Director, Credit Investments Group) believes investors haven’t missed the boat. However, he does acknowledge investors are worried.

Lawi says you can essentially divide the market into two different cycles over the last three years. In 2021, the market was very robust with the broadly syndicated market competing for deals with direct lenders resulting in spreads tightening. During the middle of 2022, a period of volatility began, with banks retreating from the market and spreads moving wider. 

“At that moment private credit really had a field day,” says Lawi. “Now, however, we have moved back towards a more normalized market, something in between those two periods. While market spreads may be back to 2021 levels, overall yields are still quite high and we are still able to get double-digit yields on individual deals today.” 

On a historical basis, private credit returns in a zero-rate world, which is much of what we lived through during the last decade, were 7 to 8% unleveraged, adds Lawi. “Today we're at a 300-plus basis point premium to that, and so individual deals may yield over 10%,” he says. “The key question is how much of that excess return can lenders retain versus defaults and recoveries,” he added. This is a crucial hurdle to ensure competitiveness against alternative assets.

“Satellite” opportunities

The same supply and demand dynamics that defined the early periods of private credit (where banks just pulled up the shutters) are playing out now in the non-sponsored part of the market (i.e., loans to companies and assets that are owned by founders, family offices and smaller publicly traded companies).

Wasson argues these dynamics are creating some attractive opportunities for investors who focus there. “A wealth of further opportunities lies at the smaller end of the lending market. And the terms on loans to companies and assets that are owned by founders, family offices and even sometimes small publicly traded companies can be eye-catching", he says.

Supply for non-sponsor owned borrowers is essentially declining because large middle market direct lending funds are laser-focused on private equity-owned companies and on ever larger loans (now regularly making multi-billion dollar loans that compete with the broadly syndicated loan market).

The lending pullback of regional, mid-size and local banks has been accelerated by the outflow of deposits (as acutely felt by SVB, First Republic and others), along with the onset of regulatory capital accounting rules. And now strain in their commercial real estate loan books is exacerbating the issue.

Echoing Rulli’s sentiments about private credit in general, Wasson refers to the non-sponsor segment as straightforward “meat and potatoes” lending. Its familiar and understandable nature distinguishes it from some of the more technical and opaque niches in private credit such as litigation finance, aviation finance or pharmaceutical royalty finance that could in theory also diversify a private credit portfolio.

Thanks to the more lender-friendly supply/demand dynamics in this satellite, non-sponsored part of the market, Wasson highlights lenders can insist upon and still may get “lower-leverage, strong covenant protection and higher spreads”.

In terms of what the future holds, the asset class looks set to continue to attract attention from institutional and individual investors alike. The current high-rate environment is persisting longer than market participants may have initially expected and that could provide a tailwind to investor returns in coming years. However, credit selection and picking cycle-tested managers will be important considerations for investors.

C-04/24 NAMT-895

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