What should business leaders know about Private Credit?

By John Carlin, Managing Director, Capital Markets and Advisory, and Jeffrey Kung, Managing Director, Capital Markets and Advisory | Published October 2024

Private credit has grown rapidly in the leveraged lending landscape over the last two years – and, in our view, it is here to stay. For mid-sized companies, that’s a positive development. Private credit is now a permanent “third leg of the lending stool,” existing alongside institutional term loans and high yield bonds as another option for corporate financing needs.

_{PitchBook | LCD • Data through Sept. 9, 2024}

Private credit is not new; it’s been part of the funding ecosystem for years. Also known as direct lending, private credit represents loans that are negotiated directly with companies and sponsors and are made by a non-bank source, often a fund affiliated with a traditional asset manager, and increasingly, private equity groups. That differentiates private credit from rated institutional term loans (which are also called leveraged loans, broadly syndicated loans or BSLs), or from publicly issued high yield debt, both of which are arranged by an investment bank and syndicated among a broad group of institutional investors.

How private credit grew its share of the lending market

Though private credit has been around for over 20 years, its growth has been meteoric in the last decade. Private credit deployment accelerated in 2022 as interest rates rose and the traditional leveraged loan and high yield bond markets experienced volatility. Amid aftershocks, some banks pulled back on their corporate lending and, due to the turmoil in the liquid markets, became more cautious on underwriting new transactions.

As these forces contracted the traditional lending markets, private credit stepped in to fill the gap, significantly expanding its market share. A high-rate environment drove strong returns in these private credit funds on an absolute basis, fueling investment from insurance companies, sovereign wealth funds, family offices, pension funds, and retail wealth channels.

Some of the growth also arises from the proliferation of the private-capital ecosystem, since private credit funds are increasingly owned by or affiliated with private equity groups. As sponsors have expanded their role in capital markets, private credit funds have followed, as the majority of loans made in the direct lending market are to sponsor-owned companies. Investor appetite for private investment structures is deep, with institutions and private entities enthusiastic about the attractive risk-adjusted returns and investment alternatives provided by private credit vehicles.

Why private credit is here to stay

Given that private credit addresses unique use-cases, it has carved out a growing niche in the lending markets. In certain situations, private credit has strong appeal for small and mid-sized companies that may be less suited to traditional, more regulated debt markets — including those companies that require higher leverage, information discretion, or unique lending metrics.

Private credit firms are now well entrenched. They have built extensive credit, research, and marketing functions, and sales teams tasked with creating relationships with private equity firms, similar to the sponsor-coverage models of investment banks. Many private credit groups have distinct industry and other field specialties to differentiate from other firms, or to mirror focus areas of the private equity arms that own them. Some direct lenders are part of pension funds or insurance companies, or own a life and annuity insurance subsidiary, creating a permanent source of funding. Many parent entities of these direct-lending arms boast assets under management that rival the largest banks, and most of them see direct lending as an attractive growth engine.

Comparing private credit, institutional term loans/BSLs and high yield bonds

Private credit loans are not for every company or situation. There are advantages and disadvantages of a private credit loan compared to high yield bonds or BSLs. Broadly syndicated loans (BSLs) and private credit loans share the greatest market overlap as both are loans (not securities), usually floating rate debt, and senior-secured in the capital structure.

However, there are also notable distinctions between BSLs and private credit loans. BSLs, as the name suggests, are distributed to a larger number of lenders. They’re also supported by an active and developed secondary trading market, which can give BSLs observable trading prices.

Private credit loans, in contrast, are usually made from a single or small club of non-bank lenders and do not require credit ratings or marketing processes. These loans are also held to maturity and therefore do not openly trade in any market, allowing for more information discretion. However, the borrower will likely endure higher interest costs and a tighter credit document (including a maintenance covenant) to take advantage of these attributes.

_{Source: PitchBook | LCD Data through Sept. 11, 2024}

In comparison, high yield bonds are securities regulated by the SEC, requiring increased disclosures and a more legally regimented marketing document. This type of financing tends to be used by larger companies who often use high yield issuance for general corporate funding purposes. High yield bonds are typically issued with a fixed interest rate — unlike BSLs and private credit — which could make high-yield rate pricing more appealing in a rising-rate scenario. Similar to BSLs, high yield bonds also have a developed and liquid secondary trading market and observable trading prices.

A midsized issuer should therefore consider their goals and risk tolerance in choosing which market to issue in.

Private credit could be the best option if the goal is:

• Efficiency: Borrowers only have to deal with one or a small club of lenders. Ratings are not required and there is no need to conduct a marketing process for institutional investors.
• Flexibility: Private credit solutions can sometimes offer features that are less available in the BSL market, such as higher leverage. They may also offer certain issuer-friendly terms, like paid-in-kind (PIK) interest (where coupons can accrue to the loan balance instead of being paid in cash), or large undrawn commitments to fund yet-to-be identified future acquisitions. Private credit lenders have also been more receptive to early-stage companies, lending on recurring revenues more aggressively than either the leveraged loan or high yield market.
• Ease of use: For amendments or additional capital needs, the company may only have to go to one decision-maker (as compared to a large syndicate).
• Discretion: As private credit deals do not require ratings or a syndication process, the company’s information will not be published in a ratings report and will only circulate among the small lender group.

BSLs or high yield could appeal more if the goal is:

Cost: In general, the spreads for broadly syndicated loans are often tighter than direct lender solutions. In an environment where rates are inverted, high yield often produces the lowest cost of capital at issuance.

Diversification: A company may want a diverse group of lenders holding their loan to have multiple sources of capital and avoid being beholden to one lender if there is a credit issue. Diversity in the lending group may also allow for better terms for the company overall as lenders compete with each other for the loan.

Market information: More-liquid BSL loans and high yield bonds trade in the open market. This could provide valuable information to companies about the market’s opinion of their business, better illuminating opportunities to lower overall cost of capital. Future rating upgrades could also open up new capital markets opportunities for larger companies to gain more flexibility or cheaper coupons.

Market depth: In general, larger companies who need multi-billion dollar financings will find it more efficient to raise capital in the BSL or high yield markets, given the depth and liquidity of these markets. However, private credit has begun to make inroads here, funding larger deals in recent periods.

Raising the company profile: If a company wants to broaden its investor profile and audience, for example, to prepare for a potential IPO or other securities offering, the BSL process may add value.

Embracing the new lending landscape

Mid-sized companies and private equity sponsors now have a range of financing solutions, enabling them to optimize borrowing decisions. With strong supply and demand, the private credit market is here to stay. When mid-sized companies are considering their financing options for acquisitions, debt refinancing, or other general financing needs, a trusted advisor can help provide guidance on market dynamics and the relative appeal of the available options.

Actions to consider:

• Rank your funding goals. Since private credit offers different benefits than BSLs and high yield, it can be helpful to write down your funding goals and rank them in order of priority.
• Explore all the options. Capital management is an important strategic advantage, so mid-sized companies should be thorough in exploring all lending options.
• Seek guidance on pricing and process. Dynamics change constantly in lending markets, but companies can get a sense of pricing, process, and timelines from a trusted adviser.

Consider your options

Is your firm evaluating the lending market and considering leveraged loans, high yield issuance, or private credit?

Contact us