Private credit has been in the headlines recently – but often for the wrong reasons. This fast-growing class of lenders draws on funds from institution such as pension or sovereign wealth funds, along with wealthy individuals, to provide credit directly to companies.
Such funds have roughly doubled in size over the past five years globally, and now have around US$2.1 trillion in assets under management, according to the International Monetary Fund (IMF).
UBS chairman Colm Kelleher has argued that there is ‘an asset bubble going on’ in the asset class
This explosive growth, however, is drawing scrutiny. The IMF itself dedicated a full chapter to private credit in its semi-annual Global Financial Stability Report – a twice-yearly publication dedicated to looming threats to the international financial system. Veteran JP Morgan chief executive Jamie Dimon recently said there could be ‘hell to pay’ if private credit sours, while UBS chairman Colm Kelleher has argued that there is ‘an asset bubble going on’ in the asset class.
On the other hand, few would deny that private credit funds have been a boon to businesses – filling the void left by banks in lending to smaller and medium-sized companies as tighter regulation has made that more challenging. While highlighting the potential risks posed by private credit, the IMF has also recognised that it has ‘created significant economic benefits by providing long-term financing to corporate borrowers’.
So, how should companies view the growth of this form of credit? And what are the pros and cons for financial chiefs of borrowing from these funds compared to bank lending, bond issuance or syndicated loans?
More availability
First, companies should probably expect this form of credit to become even more available over coming years. BlackRock, the financial services firm, expects assets under management for private credit to continue to expand at a rapid pace, hitting US$3.5 trillion by the end of 2028.
This expectation partly reflects a growing eagerness of financial institutions and wealthy individuals to invest in private credit, based on its track record of high returns and relatively low volatility. With most major central banks expected to cut rates this year, the appetite of investors for extra returns is likely to intensify still further.
Lending to support small- and medium-sized enterprises has become far less attractive for banks
Demand from businesses in search of credit should also grow, if other top sources of borrowing continue to become harder to tap. The IMF has observed that private credit originally emerged ‘about three decades ago as a financing source for companies too large or risky for commercial banks and too small to raise debt in public markets’. And all evidence suggests that both bottlenecks on credit have been tightening in recent years.
Lending to support small- and medium-sized enterprises has become far less attractive for banks, as they have been compelled to hold ever larger capital buffers against such loans. The Federal Reserve’s survey of bank senior loan officers has underlined that this trend has been continuing.
Meanwhile, barriers to entry for borrowing in public markets have also been going up, according to BlackRock. The average deal size for issuing high-yield bonds in the US has been above US$700m over the past three years, and has been trending higher. ‘For a middle-market firm seeking funding from the public markets, these “average” sizes are prohibitively large and unrealistic,’ BlackRock has argued.
Supporting smaller companies
But the appeal of private credit goes well beyond the reduced availability of other options. The leading funds have a remarkable level of flexibility in lending to smaller firms with higher debt levels. While the IMF is concerned that this could lead to default levels, it can be helpful for smaller companies in need of cash.
The IMF has calculated that the median borrower in the high-yield bond market has total assets of $4.5bn and holds debt of just below four times EBITDA. By contrast, the median borrower from private credit funds has just US$500m in total assets and debt of approaching five times EBITDA.
‘Private credit funds can make it easier for companies to plan with confidence’
Along with this greater flexibility to lend to a broader range of companies, private credit funds can also offer greater certainty and speed of execution. ‘A company can’t fully nail down the cost of borrowing for a syndicated loan or a bond issuance until the last minute, since this can be affected by market conditions,’ observes Dr Andrew Hilton, director of the Centre for the Study of Financial Innovation. ‘Private credit funds can make it easier for companies to plan with confidence, and also deliver cash with much shorter lead times. That is a pretty appealing combination for businesses.’
Tailored to needs
An additional perk is the ability to tailor the loan terms to fit a company’s specific need – such as deferring interest payments for faster-growing firms or the option to delay drawing on a loan until a particular acquisition target becomes available. Many of the top private credit firms – such as Blackstone and KKR – have their roots in private equity, buying and overhauling undervalued companies as a partner. ‘You can see the same ethos in parts of private credit, with funds providing deeper guidance and expertise well beyond just offering loans,’ says Hilton.
Of course, it can come with greater restraints, including stricter covenants, along with higher costs. Private credit loans typically have a price tag of around 100 to 300 basis points above syndicated loans for a company with a similar profile, based on an estimate by Bloomberg from earlier this year.
And while the supply of private credit is abundant at present, companies face the risk that the tap could be turned off if economic or market conditions worsen, according to a recent report from the Bank for International Settlements. The primary concern raised by the IMF in its Global Financial Stability Report was also that there could be ‘significant economic implications should stress in private credit markets result in a pullback from lending to companies’.
This conclusion itself appears to concede the point that businesses are better for the rise of these nimble and deep-pocketed lenders.
