Dissecting private credit

Key takeaways

1. Market segmentation within direct lending can help investors differentiate opportunities and risks associated with investing in private credit.
2. We expect greater dispersion in private credit and believe a greater focus on underwriting, documentation and engagement with borrowers is critical to driving better long-term results.
3. We believe the core middle market offers a complementary investment profile to more widely sold upper middle market private credit, driven significantly by yield premiums and stronger documentation with greater use of loan covenants.

A heterogenous market?

Current press surrounding private credit may lead you to believe that the market is a monolith – a large block of loans that broadly look the same. The reality is quite different. As the US$1.7 trillion global market (per Preqin as of December 31, 2023) continues to expand alongside demand from new investors, we see a significant need to improve transparency and understanding of private credit market segmentation, particularly in corporate direct lending, which is the largest sub-component of the market. Direct lending represents approximately 46% of the global market according to Preqin, while the rest of the market includes categories such as distressed debt, special situations, opportunistic and venture/growth lending.

Segmenting direct lending

Dividing an asset class into pieces is nothing new: large vs. small market capitalization, growth vs. value, or developed vs. emerging markets . These divisions have helped investors understand common characteristics, risks and opportunities for investing across asset classes for years. We typically segment the private credit market into lower, core, and upper middle markets based on a business’s earnings (Exhibit 1).

Exhibit 1: Summarizing the major segments of direct lending

Key characteristics for market segmentation

1. Company Earnings – Business lifecycles typically start with a period of significant growth and risk as small companies seek to create traction to increase scale and profitability, which in turn helps attract additional investors and enable further growth. Dividing the private credit market based on earnings (usually EBITDA) helps us consider businesses at different stages in their development, needs they may have and resources required to withstand potential market challenges.
2. Company Growth Stage – Smaller and earlier stage of life businesses often seek loans from commercial banks or private credit providers. As companies become larger and more established, their stability typically improves and their access to capital evolves. They may need multiple lenders to provide the scale of capital required, and eventually they may become large enough to publicly issue debt through investment banks, which syndicate those positions into the public markets.
3. Loan Terms – Directly originated loans are typically held to maturity, so it’s important to have terms that protect lenders in the event of unexpected outcomes. Loan documentation is highly bespoke for middle market companies, and smaller businesses typically have more contractual requirements to protect lenders, all else equal. Larger deals by comparison often attract more interest from a wider universe of lenders, resulting in a more competitive market and typically less structural protections.

Threading the needle: the core middle market

We have a long-standing preference for investing in the core middle market. We prefer businesses that are large enough to have operating history and established scale to underwrite the borrower, and generally avoid larger borrowers with more competition for capital from private credit lenders and investment banks that feed the broadly syndicated loan markets.

A significant factor in underwriting is the ability to control terms and incorporate loan covenants (see Exhibit 2). The chart shows that roughly two thirds of loans below $250m have covenants which we view as critical to protecting lenders from businesses that may run into challenges. This gives us (the lender) an opportunity to engage the company and help create an outcome that protects our investment prior to a payment default.

Exhibit 2: Smaller loans have greater lender protections
Percent of deals with maintenance covenants by deal size

Understanding covenants

The purpose of a covenant in a middle market loan agreement is to define a set of conditions that the borrower must adhere to during the life of the loan. Most covenants are tied to metrics such as leverage, interest coverage or liquidity. If a borrower ‘trips’ a covenant, for example by taking on too much debt or not having enough liquidity, the lender can take action to protect its loan up to and including a forced repayment.

In practice, the relationship between borrower and lender in the middle market is a critical partnership, and covenants provide a structural way to compel good behavior. In our experience, the relationship and the willingness to be a strong partner to the borrower creates an alignment of interests important to both parties, while the loan documentation, including covenants, ensures conditions remain true even if the business faces unexpected challenges during the life of the loan.

Segmentation in the context of today’s credit market

The private debt market has grown at a roughly 20% compound annual growth rate (per Preqin as of 31 December 2023) since 2020, and we expect it to continue to grow at a roughly 15% rate over the next five years. We may see increased performance dispersion because a slower economic cycle and higher interest rates put stress on some borrowers.

Capital deployed prior to the 2022 Federal Reserve interest rate increases is more likely to experience some level of performance dispersion because of the meaningful increase in interest rates and the impact of a higher cost of debt in a slower economic cycle. Manager performance dispersion is also more likely to occur as managers without market cycle experience navigate the new regime. Unlike public markets where price transparency is achieved through continuous market making, in private debt markets each loan is directly originated and typically held to maturity or refinanced, so the process of realizing market dispersion is naturally slower.

We expect the upper middle market will experience this dispersion earlier, and that loan documentation, covenants and investment team experience will be more critical this cycle. The core middle market can provide a complementary investment opportunity from a curated portfolio of sponsor and non-sponsor supported core middle market businesses across a wide range of sectors which typically offer premium pricing with tighter loan documentation inclusive of covenants.

We believe our preference for core middle market direct lending may be an attractive option as more investors come to understand the nuances of private credit and look to complement their existing credit exposures.

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