Interest in alternative assets has grown substantially since the Great Financial Crisis (GFC) as institutional investors have looked for various ways to generate attractive risk-adjusted returns outside of their traditional stock and bond portfolios. Private equity asset classes such as venture capital, growth equity and leveraged buyouts (LBOs) have been large benefactors of this shift to alternatives, growing assets under management (AUM) from roughly $287 billion in 2009 to over $1.2 trillion at the end of 2021. Another alternative asset class which has seen significant growth in AUM is private credit, consisting of direct lending, special situations, mezzanine and distressed debt. As interest rates hovered close to zero for more than a decade, these private credit strategies provided debt financing to businesses at rates much higher than what investors could find in the public markets.
As seen in this week’s chart, private credit dry powder – or capital that private credit firms have to deploy – has grown to over $400 billion as of August 2022. In addition, private credit was the only private asset class to grow fundraising every year since 2011, including during the pandemic. Most of the large private equity firms such as Apollo, Blackstone and KKR have private credit arms that are large enough to compete against banks like J.P. Morgan, Goldman Sachs and Morgan Stanley. There are also firms specifically focused on private credit such as Blue Owl, Golub and Antares Capital. Each firm may focus on different strategies within private credit, but the goal is the same: to provide consistent risk-adjusted returns while protecting investor capital.
Currently, debt markets are strained and large companies are reaching out to some of these larger private credit firms looking for loans to ride through inflation, supply chain and general economic uncertainty on the horizon. In addition, with the amount of money raised by private equity over the last ten years, there are more private-equity backed companies than ever looking for private credit solutions in order to execute on mergers and acquisitions (M&A) or strengthen the balance sheet moving forward. These private credit solutions tend to be more expensive than debt financing a company would get in the broadly syndicated loan market and tend to be short duration (24-36 months). There are a couple reasons why these loans tend to be more expensive: the company is struggling and requires an immediate financing need; the business is smaller in size; and private loans are much more illiquid than publicly-traded debt. Furthermore, the loans are typically held to maturity by private credit investors unless they are refinanced early, in which private credit investors may generate a high internal rate of return (IRR).
When providing private loan financing, investors will look to strengthen the covenant package, negotiate a SOFR / LIBOR floor to hedge against decreasing rates, and most of the time will provide a floating-rate loan, giving the investor a hedge against rising rates as well. Private credit investors will typically look to lead the deal in order to negotiate covenants and structure it in a way that is advantageous to the investor. However, the goal is to allow the business receiving the loan the flexibility and capital to execute on strategic initiatives, M&A or ride through an economic rough patch, which some companies are struggling with in today’s business climate.
The emergence of this asset class is due to several tailwinds – the first being the withdrawal of banks willing to provide financing to businesses, mostly in the middle market. In 2013, the lender in 58% of sponsored middle-market deals was a regulated bank lender. In 2021, only 11% of sponsored middle-market deals were underwritten by a bank lender, with the other 89% being underwritten by a nonbank lender or private credit firm. Second, private credit firms are able to move much more quickly than banks in underwriting a deal from start to finish. Third, as mentioned previously, the amount of private equity capital raised over the last decade has grown significantly as deal buyout volumes are nearly three times higher than they were ten years ago, leading to more demand for private credit solutions. Finally, with interest rates close to zero for much of the last decade, institutional investors needed to find alternative ways to possibly generate risk-adjusted returns, and private credit is one area that has appealed to investors.
Given the uncertainty in the economy, many companies are looking for private credit solutions in order to shore up the balance sheet, execute on M&A or deploy capital for other strategic reasons. With the expansion of private equity AUM and buyout volumes over the last ten years, the white space for private credit and nonbank lenders, particularly in the middle market, has grown significantly as well. Inflation and supply chain issues, among other factors, have forced management teams to re-evaluate their businesses, forcing some companies to raise expensive private debt financing in order to ride out the storm or take advantage of opportunities in the market today. Thanks to these reasons, along with the potential for attractive returns that private credit solutions can provide, I believe private credit will continue to grow as a means of providing private financing to companies of all shapes and sizes.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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