Private credit has emerged as one of the fastest-growing asset classes in the 2020s, growing to a comparable size to the publicly traded junk bond market.
Morgan Stanley (NYSE:MS) estimates that, despite skyrocketing interest rates in recent years, the size of the private credit market at the start of 2023 was approximately $1.4 trillion, compared to $875 billion in 2020.
In fairness, this does come with a $500 billion-sized caveat: Up to a third of this capital is still sitting in the barrels as dry power, meaning a fair whack of it going unused.
Nonetheless, it is estimated to grow to $2.3 trillion by 2027, dry powder or not, making it serious business for borrowers, lenders and investors.
But what exactly is private credit, and why has it taken off to such an extent?
What is private credit?
Like its better-known brother private equity, private credit is a form of financing offered outside of the traditional banking industry. It is also not traded on the public markets.
Private credit typically involves direct lending to private companies that are often backed by private equity firms.
For lenders and borrowers, It offers advantages over broadly syndicated loans, like the certainty of execution, simpler capital structures, and the absence of rating agency processes (yes, private credit, for better or worse, is always unrated).
The practice typically involves lenders and borrowers directly discussing and agreeing upon the terms.
This direct negotiation often leads to more favourable arrangements, characterised by reduced leverage, the provision of extra collateral, and the inclusion of maintenance covenants.
Investors find private credit attractive due to its stable and consistent yield, its floating rate nature that provides interest rate protection, and the prevalence of illiquidity premiums which can be significantly wider for opportunistic, distressed and subordinated debt.
The illiquidity of private credit, while contributing to higher yields, also means it’s less correlated with public markets, offering countercyclical opportunities.
Who provides private credit?
Private equity firms are themselves the main providers of private credit, allowing them to structure investments using a mix of debt and equity.
Wall Street giants like Apollo Global, Blackstone (NYSE:BX), KKR and Carlyle Group (NASDAQ:CG) dominate the market, though smaller private equity firms also get in on the action.
One of the biggest vehicles for investors is the Blackstone Private Credit Fund (BCRED), holding around $50 billion in investments at a fair-value calculation.
Why has private credit become so popular?
According to Blackstone, “private lenders often act as partners; their presence can be especially valuable during challenging market environments”.
“We believe that several of the drivers of the field’s growth boil down to private credit’s appeal as a funding source for borrowers, even considering the higher rates borrowers tend to pay.
“In the private credit market, the execution of transactions is relatively rapid when compared to public markets, and there may be greater certainty that deals ultimately close as there are generally no changing terms depending on market conditions between signing and closing.”
BlackRock (NYSE:BLK) noted that, since the global financial crisis, public credit markets have remained closed to many growth-oriented companies, “leading them to seek private lenders to diversify their capital sources”.
For investors, private credit provides income generation, a countercyclical investment timeframe and portfolio diversification.
According to Morgan Stanley, private credit generated higher returns relative to volatility when comparing it to syndicated bank loans and high-yield bonds.
What are the risks of investing in private credit?
Investing in credit always comes with default risk and since private credit is unrated, it requires a dependence on the robustness of the lender’s due diligence into the borrower.
Though a feature, private credit’s floating-rate nature can also increase default risk in times of surging interest rates.
While illiquidity is also cited as a feature, it too is a risk. Since private credit investments are less liquid than public market investments, investors need to consider the liquidity of their entire portfolio.
Since private credit is unlisted, it is more opaque in nature, as its market value is not determined on a real-time basis.
Additionally, investing in private credit funds comes with fees and expenses that can reduce returns.