What is Private Credit

Private credit, or private debt, represents a rapidly growing asset class. In the aftermath of the 2008 Global Financial Crisis, traditional banks de-risked their balance sheets and tightened lending standards. These actions created a void in the lending market that was filled by non-bank (private) lenders, giving rise to an alternative lending avenue and novel asset class. This quarter’s investment perspectives piece focuses on private credit, what it entails, its market size, significance, associated risks, and why it’s increasingly attractive to investors.

Understanding Private Credit vs. Private Equity

Private credit is a form of financing where non-bank lenders provide loans or other credit instruments to private companies. These instruments are not traded on public exchanges and, generally, not rated by rating agencies. Private credit caters to a wide range of borrowers, particularly middle-market companies (companies that occupy the range between small “Mom & Pop” businesses and major enterprises) that may struggle to secure traditional bank loans. Private lending can also extend to companies with an average enterprise value of $3 billion or more. This mechanism offers borrowers access to capital with greater flexibility and customized loans, with the advantage of speed, anonymity, and execution certainty.

In contrast, Private Equity (PE) is a type of investment that involves buying or acquiring private companies that aren’t listed on a public stock exchange – an investment quite different from Private Credit.

The Size and Growth of the Private Credit Market

The private credit market has expanded significantly in recent years, with estimates currently placing it at approximately $1.5 trillion, according to HarbourVest. The industry’s trajectory has been remarkable, with a compound annual growth rate of 20% since the end of 2018. It is projected to reach a staggering $2.3 trillion by 2027, as forecasted by Blackstone.

There are over a thousand private credit funds, half specializing in direct lending strategies. The other half includes distressed debt, mezzanine, special situations, venture debt, and private debt fund-of-funds. Despite this impressive growth, excess demand should fuel growth for many years.

Why Private Credit is Important Today

Private credit provides a vital service to the market. First, it is a critical source of capital for middle-market companies, which form the backbone of the economy. Traditional banks have pivoted away from lending to this segment of the market. Private credit, particularly direct lending, has stepped in to bridge this funding gap.

Second, private credit has lower credit risk than traditional non-investment grade (loans that are not from the government or the highest quality large corporate issuers) fixed-income investments. Private debt lenders tend to conduct extensive due diligence before extending credit, resulting in historically lower default rates relative to public fixed income. For instance, according to Ares Management, from 2004 to 2023, middle-market private credit had default rates of 1.8%, compared to 2.4% for high-yield bonds and leveraged loans.

Third, private credit has historically provided higher risk-adjusted yields. Over the past two decades, these loans have generated a substantial spread over the leveraged loan market and high-yield bonds while maintaining lower annual loss rates.

Additionally, private credit offers a level of protection against interest rate risk because their rates float (or reset) with changes in interest rates, allowing investors to benefit from rising interest rates while maintaining relatively stable prices.

Finally, private credit has exhibited greater price stability than publicly traded equivalents. Loans in this space are typically held as longer-term investments, resulting in reduced mark-to-market pricing volatility, making them easier to hold for the long term.

Private Credit Benefits for Investors

Investors appreciate private credit for these unique benefits: lower volatility, higher yields, and lower default rates. Furthermore, the lack of liquidity of private credit assets provides an illiquidity premium that can enhance returns.

Private credit emphasizes current income and regular distributions, typically 8-12%, making it an appealing option for those seeking reliable income.

Investors are also drawn to this asset class for its diversification benefits, which help reduce portfolio volatility and potentially improve overall returns.

Risks Involved with Private Credit

There are risks involved, as well, one of which is illiquidity. Private credit investments lack a robust secondary market, making them less tradable if investors wish to sell. Credit and default risk exist with all debt, and some borrowers have issues of creditworthiness, which brings them to the private market. Also, higher rates put pressure on the borrower’s payment obligations and can ultimately lead to financial distress.

Accessing Private Credit Investments

Investing in private credit can be accomplished through various means. Private credit funds are typically structured as drawdown vehicles, like private equity funds, with a shorter fund life. Recently, a number of funds have emerged in the form of evergreen vehicles, like non-traded Business Development Companies (BDCs). These BDCs feature beter, though limited, liquidity and enable accredited investors to participate without producing a K-1 form at the end of the year.

Private credit manager selection is a critical factor. Investors should assess a manager’s historical returns, strategy, experience, and sourcing capabilities to ensure a prudent investment choice. Most of our investments in private credit involve first-lien senior-secured positions with lower leverage at the fund level.

Private Credit is one of several alternative investment options we may utilize when managing client portfolios at Aureus. If you are interested in learning more, we are available to discuss the appropriateness of available investment opportunities and how these may apply to your specific circumstances.