The evolution of private credit – what next?

News: Insight & Opinion | 27 March 2024

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Private credit is now the second-largest private market strategy by annual fundraising (after private equity), having overtaken venture capital. According to Pitchbook, in 2023 an estimated >$200 billion was raised by institutional funds for the fourth consecutive year. Overall AUM is estimated at $1.9 trillion, with the growth rate outstripping private equity.

As the market has grown, private credit strategies have evolved, and some are now demonstrating the ability to outperform private equity strategies on a risk-return basis. As a result, the asset class is no longer just the preserve of more conservative institutional investors. It’s through this broadening and innovation - and the consequent range of options to gain exposure to the asset class - that private debt has now firmly cemented its position as an essential component in a diverse portfolio.  

In this article Lorna Robertson, Head of Funds at Connection Capital, looks at how the private credit market has evolved, what it now offers investors, and considers what next? 

The impact of the Global Financial Crisis - a catalyst for change in private credit 

The growth of the private credit asset class is in large part due to the structural changes in the financial services industry occurring post-Global Financial Crisis in 2008. Although banks had already been consolidating throughout the 90s and reducing their lending to SMEs, it was the onset of restrictive regulation brought in after the GFC that led to a deep and accelerated retrenchment in traditional bank lending.  

Like nature, private markets abhor a vacuum and the growing number and diversity of private credit funds have sought to fill the growing supply gap left behind by the traditional lending sector. Income-seeking investors piled in looking for alternatives and complements to bonds and gilts, attracted by the diversification offered and high target return rates from an asset class that often has downside protections built in for investors and has historically posted much lower loss ratios than public credit. 

Blurred lines and current areas of interest 

As the market has matured, private credit strategies have evolved. There’s been a blurring of the line between where private credit stops and PE kicks in, especially with the increase in the number of opportunistic strategies, hybrid capital solution options and the growth of the number of sponsorless debt deals. 

At one end of the credit spectrum, some lenders concentrate on offering senior, secured debt and in doing so, often take a conservative and passive approach to investing, essentially replacing the banks that stepped away. At the other end of the spectrum there are a growing number of lenders willing to take a more pro-active approach to supporting a company and its finances and can be more creative with the capital structure of the transaction. These kinds of strategies are often capable of generating PE buy-out like levels of return i.e. 2.0x MOIC – through taking an equity stake in the borrower but have the added benefit of downside protection through the debt element, including upfront fees and contractual interest payments. 

It is this more creative area of the private credit market that is of particular interest to us. Managers in this space typically consider ‘complex’ situations and consequently, they offer more flexible, bespoke capital solutions to corporate borrowers than just a pure debt or equity solution, they are instead capable of taking a hybrid approach.  

Typically, these managers know how to restructure a company’s balance sheet if required and also tend to have private equity experience, dealing with the challenges of running businesses and interacting with management teams. These skillsets and experiences mean these managers offer a best of both worlds to both borrowers looking for flexible capital solutions to meet their needs and also investors who are searching for income and the potential for upside through equity participation. 

The traditional debt financing model of earning returns through fees and contractual payments has therefore flexed in recent times with embedded upside targeted through equity options. When considering managers and strategies in this space, it’s now a case of exercising caution and undertaking due diligence carefully to understand whether debt is the right funding option for the underlying transactions: assessing the risk and being 100% sure what is driving the fund returns. Is this really just an equity play in debt clothing? 

Flexible capital solutions strategies are buoyed by current impact of interest rates  

For now, interest rates remain high. This means private equity firms, that make use of leverage to acquire companies, are demanding more equity from their target companies. Understandably many companies are unwilling to agree to this! As a result, PE has become less attractive as a source of financing to many companies globally.  

There are few gaps in private markets for long and consequently, those lenders who are willing to offer less dilutive and more flexible capital solutions e.g. a blend of debt and equity to borrowers, accepting less equity in return for higher degrees of secured return from the debt part of the investment, are filling this space.  

Adapting liquidity horizons: the impact of private wealth on private credit strategies 

There are other evolutions afoot too and these have responded to another mega-trend, that of new types of investors pouring into the private credit asset class (and private markets in general). The   surge of private wealth into private market strategies means fund managers are having to move away from the traditional institutional fund structures, to become more flexible and adapt to suit the needs of this growing investor class. While institutional investors are able to manage illiquidity, planning years into the future to manage their liabilities, private investors have much shorter and often capricious attitudes to the lock-up historically associated with private market funds. 

As a result we are seeing an increase in managers offering ‘semi-liquid’ or ‘evergreen’ funds. Vehicles operating these strategies attempt to offer investors shorter hold periods and the ability to redeem their investment (subject to various constraints) at their discretion, in line with the liquidity offered by public market funds.  

The appeal of liquidity to investors is clear, but there are other features of interest too. As the fund is ‘evergreen’ and constantly recycling investors’ funds, new investors’ capital is deployed quickly and all at once (unlike traditional private credit strategies which are more likely to deploy capital via a series of capital call/drawdowns over a number of years). So, investors' capital is put to work sooner.  

What is the outlook for private credit? 

We believe that the current market environment is favourable for opportunistic credit strategies and right now represents an inflexion point for the asset class, with the potential to create a vintage era for those investing now. There is an increasingly diverse range of strategies available to choose from and good managers, across all of these strategies, should be able to lock in good deals at attractive pricing before interest rates fall again in the longer term. 

We should not ignore the potential risks associated with a lower rate environment in the future for the asset class. Lower base rates would mean tighter credit spreads, ultimately reducing returns and increasing refinancing risk. This could force managers to look for riskier investments to generate returns. Then there is duration risk, a lower rate environment may lead to an increase in longer dated debt, so lenders have increased duration risk should rates rise in the future. Then there is the possibility of increased competition as the asset class grows, increased pricing pressure, this could lead to reduced lending standards and the potential of increased default risk.  

 Ultimately, for investors it’s a case of taking all these factors into consideration, with stringent risk management, consistent investment selection and maintaining discipline in underwriting. Reassuringly, the asset class has demonstrated adaptability and resilience in recent years, and it is fair to assume that it will continue to do so. 

Concluding remarks and investor takeaways 

Recent innovation in private credit means that investors looking for higher potential returns but with lower equity risk are now genuinely able to consider the asset class. Funds that are offering flexible capital solutions can now reasonably have their returns measured in multiples rather than IRR (internal rate of return), offering a complementary sub-asset class to private equity, but with debt-like protections.  

We believe this best of both worlds approach is extremely appealing to investors. The confluence of maturation and innovation in the market and the unappealing terms offered by PE means strategies offering companies a compromise have fertile ground to plough. Throw in shorter fund terms, frequent distributions and liquidity too and you’ve got the makings of something that savvy investors should be taking a look at.