The Rise of an Asset Class
Few examples in our capital markets history can compare to the rapid rise of private credit as an asset class. Before the Global Financial Crisis, private credit was relatively obscure. There were certain insurance firms providing private fixed rate bonds to smaller companies with investment grade credit profiles, and a handful of BDCs and SBICs but nothing like what we’re seeing today.
As the health of the banking sector deteriorated post 2008, and bank regulation increased, bank lending declined and private capital swiftly stepped in to fill the void. Yield-starved investors were happy to dip into the market and began directing capital to the asset class. To them, the lower risk nature of a loan product and its ability to produce a steady stream of current income outweighed the relative illiquidity of the loans.
Private credit assets under management grew from $194 billion in 2007 to nearly $1.4 trillion today*, an approximate 15% compounded annual growth rate. As the market grew, so did the number of players and the types of financing available. Initially, large private equity firms expanded into private debt, followed by an increasing number of BDCs and stand-alone private debt funds serving the needs of companies both large and small. Today, the asset class has officially arrived, and is becoming a significant allocation for asset managers such as pensions and insurance companies.
Today private credit is widely available both in the U.S. and abroad. Numerous strategies have developed, whether they be sector focused, distressed, situational, large cap or mid cap. While a large portion of the capital available is focused on first lien term loans, numerous firms offer more flexible capital which can take the form of second lien, mezzanine or even subordinated debt or preferred equity.
Private credit firms are partnering with traditional banks to offer unique solutions across the capital stack as well as revolving credit facilities and letters of credit. With the growth and popularity of the asset class, the funds are getting bigger, and increasing their “bite-size” (average invested per loan) to $200 million or greater.
What started as a relatively obscure asset class offering term loans to private companies has evolved into a trillion dollar market providing solutions across the credit spectrum from asset-based loans to mezzanine and debt hybrids.
The increase in average investment size for private credit is starting to encroach on the broadly syndicated market (“BSL”) where minimum loan size has historically been around $300 million. With the post-pandemic slowness in the BSL and high yield markets, borrowers have increasingly turned to private credit for financing LBOs, acquisitions, and even refinancings. Large, multi-billion dollar financings such as those for Hyland Software, Finastra and Stamps.com have been debt financed with club private credit deals. This trend is expected to continue.
As interest rates stay at elevated levels, all eyes are on potential stress in credit portfolios as companies deal with significantly higher cash interest burdens. Fortunately, underwriting standards in private credit have remained prudent and the hope is that the asset class will fare as well as it did through the pandemic.
Borrowers are dealing with significantly higher cash interest burdens which is putting pressure on credit portfolios.
Industry observers believe the pace of growth for private credit will continue, with some estimating it will reach $2.7 trillion AUM by 2027*. As capital continues to flow into the asset class, fund sizes are likely to increase along with the average investment size. Investment banks and boutique advisory firms are growing their presence in advising borrowers on private credit raises as the universe of lenders expands and navigating the market becomes more difficult. Some firms are raising funds to purchase large portfolios of loans from banks who are coping with onerous capital requirements.
So long as traditional bank lending and institutional market remain soft, private credit will continue its run. What remains to be seen is whether increased competition and a maturing market will negatively affect underwriting standards and credit protections. Additionally, if current high interest rates are paired with a so far unseen economic slowdown, how will private credit endure the cycle? Indeed, the asset class is here to stay and for investors and borrowers alike, it’s a welcome addition to the capital landscape.
Fund sizes are likely to grow, as well as the number of banks and advisors helping borrowers navigate the market.
* Source: Prequin as of January 2023.
Headquartered in Los Angeles, CriticalPoint executes, sources, and invests in deals for the traditionally underserved middle market. CriticalPoint uniquely combines the best of both investment banking and private capital service offerings. Since our founding in 2012, our mission has been to serve the needs of owners, entrepreneurs, management teams, and stakeholders with our experience, knowledge, and expert judgment, to help them realize their companies’ greatest potential. To learn more about CriticalPoint, please visit www.criticalpointpartners.com.