What does the growth in private credit mean for investors?

Key takeaways

1. Private credit markets are undergoing a time of heightened expansion, offering investors a growing array of opportunities against a backdrop of declining bank lending and shifting risk dynamics. With opportunity comes complexity, and navigating these markets requires manager experience, investor discipline, and a nuanced understanding of risk.
2. In private markets, careful selection may drive results. Investors considering private markets may want to focus their manager selection on those with experience investing through multiple credit cycles. For managers, credit selection is critical when seeking to achieve attractive outcomes and mitigating downside risk.
3. The relative value between private and public credit is constantly evolving and is measured across multiple dimensions rather than just yields. A deeper understanding of risk exposures and downside risks may help in navigating market cycles. 

Heard in the headlines

There are those that support the growing opportunities in private debt, but inevitably there are skeptics. In the current market, there are two areas for investors to consider if they have interest in private credit: (1) the speed of growth of the private credit market and whether managers can continue to selectively deploy capital while mitigating downside risks, and (2) how to assess the relative value of private credit compared to publicly traded credit markets.

Opportunity beneath the surface

The direct lending market is an estimated US$789 billion, the largest piece of the US$1.7 trillion private debt market¹. The small fraction of deals that make newspaper headlines barely scratch the surface of the available investment opportunities, but they often influence views on the rest of the market. The substantial amount of capital flowing into private credit is of concern. As more funds flow into the private credit space, managers must remain selective to deploy capital into attractive opportunities while mitigating downside risk. Moreover, with the expanding set of opportunities in this market, investors may want to consider a manager's experience across cycles when deploying capital. We believe there are many reasons why there are potentially attractive opportunities in the private credit space:

1. The recent reduction in bank lending is driving financing to private credit markets – Since the Global Financial Crisis (GFC), bank lending as a share of overall U.S. economic activity has been in decline (see Exhibit 1). Over the next decade, an estimated $5-6 trillion reduction in bank lending is expected², which likely supports the growth of private credit as a source of replacement capital rather than additional debt in the system.
2. Private credit fundraising today is accruing primarily to established managers – more than 80% of assets raised since 2022 have gone to experienced managers (see Exhibit 2)³, suggesting the more established and experienced managers are leading the growth, versus newer entrants.
3. Illiquid fund structures allow managers to be more selective with the capital they deploy – most assets in private credit markets are held in traditional, illiquid and non-traded, semi-liquid fund structures⁴ (from experienced managers, per reason #2). While more capital may be available to deploy, it is generally ‘patient’ capital⁵ that can be deployed selectively.

Exhibit 1: A reduction in bank lending
U.S. bank lending to the domestic private non-financial sector, as a percentage of U.S. GDP

Exhibit 2: Capital formation driven by experienced managers
Fourth fund or later private debt fundraising as a proportion of total funds and aggregate capital raised (RHS)

How to assess the private credit opportunity?

Investors seek a return premium vs. traditional publicly traded credit for taking illiquidity risk and dealing with greater complexity. In other words, this is a premium sought by investors for the challenges of holding illiquid assets that cannot be quickly sold and for navigating bespoke loan structures requiring specialized manager expertise. Over the last 10 years, the average yield premium between private and public credit⁶ has been 4.2% and it has compressed in the last three years due to higher base rates and greater competition for capital (see Exhibit 3).⁷ Additionally, the Cliffwater Direct Lending Index (“CDLI”), an index of over 16,000 directly originated loans, has seen a shift to more first lien loans (vs. historically having greater second lien / mezzanine exposures).⁸ Yet, the relative value of private versus public credit remains dynamic. We believe it is important to gain a comprehensive understanding of the risks and potential downside scenarios that may affect performance. To assess the relative value of private credit, consider the following more nuanced factors:

1. Lender protections in the debt agreement – loan documentation is a critical aspect of private lending. Lenders can include specific requirements such as covenants to protect against borrower or equity owner actions that may increase risk for them. Most of the broadly syndicated loan market lacks stringent financial maintenance covenants with 90% of the market containing no covenants.⁹
2. Ability to engage with management – private loans are directly originated, either held wholly by the originator, or in a small club typically made up of 2-5 managers. This concentrated lender group may create better alignment between borrower and lender and may provide greater flexibility to work with borrowers to address business issues which may occur. In syndicated markets, loan exposure can be distributed among potentially hundreds of lenders which may make engagement difficult or impractical in the event of a business issue.
3. Third party valuations vs. market prices- The less-frequent third-party valuation of private credit is often viewed as a benefit to investors, as it typically stabilizes price performance, showing less potential distortions. Simultaneously, third party valuations focus primarily on the potential contractual cashflows¹⁰. By comparison, continuous pricing in public markets can be distorted by a variety of factors including who owns the loans, whether the loan is included in an index, and potential price movement associated with large investors, such as collateralized loan obligations (CLOs). These differences reflect distinct market dynamics and valuation methodologies. Investors may want to carefully consider how these factors may impact the perceived stability or volatility of private credit versus publicly traded loans.

Exhibit 3: Private & public credit current yields have compressed in recent years
Quarterly current yields and average yield over the last ten years for private credit and public credit indices

Conclusions

In our view, the opportunity in private credit is large and growing. However, we believe manager selection remains a critical consideration, including a manager’s potential experience over multiple credit cycles. Similarly, managers must remain disciplined in deploying capital, balancing the growing competition and compressed potential yield premiums with the need to account for downside risks. When evaluating the opportunities in the current credit market, one may benefit from a holistic understanding of the terms and conditions that influence the relative value of private and public credit.

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