The Rise of Private Credit as Traditional Banks Retreat

Private credit, loans to corporate borrowers by non-bank lenders, has gained media attention as it introduces new participants and raises capital for new funds, acting as an intermediary between borrowers and investors.

FREMONT, CA: Private credit markets have experienced significant growth for over a decade following the Great Recession. The failure of several prominent regional banks, necessitating FDIC intervention, has heightened regulatory scrutiny across the banking sector. Consequently, banks have tightened their credit standards, leading to a reduction in lending activity. Ongoing regulatory pressures continue to impact banks and their loan portfolios. Recent stress on certain regional banks in early 2024 has reinforced this trend.

As a result, corporate borrowers are increasingly turning to private credit markets as an alternative funding source. Non-bank lenders have stepped in to fill the void left by traditional banks, a phenomenon described by one market participant as "de-banking." Once limited to leveraged loans for small and mid-size corporate borrowers, this market segment now supports more significant loan issuances and even those considered investment grade.

Private credit markets appeal to investors due to their attractive risk/return profile. They offer equity-like returns with substantial credit spreads compared to other fixed-income investments. This is especially true for floating-rate loans, which track increases in the Federal Reserve's fund rate. The enhanced returns compensate lenders and investors not only for the credit risk, reflecting factors such as leverage and seniority, but also for the loans' illiquidity.

Additionally, investment returns may include premiums for borrowers' prepayment options and fees associated with loan facilities. The investor base is typically long-term focused, so they are well-positioned to realize these additional premiums.

Market participants have access to extensive data on private credit portfolios, enabling them to evaluate lender performance effectively. Banks and credit unions provide quarterly updates on their loan portfolios, offering insights into the credit performance of nearly 10,000 institutions. The private credit market, excluding banks, is estimated to be approximately $1.7 trillion. Business Development Companies (BDCs) also disclose their financial information quarterly, with the total market value nearing $300 billion. Additionally, leveraged loan funds report detailed information on their portfolio holdings in compliance with SEC reporting requirements.

Reduced Pressure for ‘Fire’ Sale

Bank lending is often financed through deposits, a funding source that can be volatile due to fluctuations in human behavior. In early 2023, several banks experienced a 'run' on their deposits, which created substantial pressure on their funding needs, as many of their assets were tied up in longer-term loans.

In contrast, private credit markets typically benefit from more stable, long-term funding sources. Private credit investment vehicles, such as direct lending funds, CLOs, BDCs, and closed-end funds, often have access to fixed liability profiles or highly predictable funding sources, such as life insurance, pension funds, and semi-permanent capital.

This better alignment between funding sources and underlying loans provides significant stability for private credit investors, acting as a buffer against liquidity crises. Crucially, this longer-term match enables investors to achieve the excess returns associated with illiquidity and other premiums inherent in private debt investments.

Active Portfolio Management

Private credit managers typically invest in a smaller number of companies, allowing for a comprehensive understanding of their borrowers and the respective industries. These managers adopt a longer-term investment horizon and are not compelled to liquidate investments during periods of financial distress. Conversely, banks often encounter regulatory pressures to maintain a healthy balance sheet, which may necessitate the sale of distressed credits at unfavorable times and prices. Private credit investors, including insurance companies and pension funds, benefit from more stable funding sources, enabling them to realize the long-term value inherent in these distressed credits.

The private credit market, particularly senior secured loans, has experienced significant growth in recent years, offering corporate borrowers a diversified funding source. This market is crucial in meeting financial needs and effectively aligns risk/return characteristics. However, this asset class's rapid expansion and size have raised concerns. Despite the market's potential for high returns, it carries inherent risks, including issues related to transparency, regulatory oversight, asset-management expertise, and effective asset-liability matching. These risks are also present in public capital markets.