Private Credit Market Outlook: Opportunities in a Changing Landscape

The private credit market is evolving rapidly, driven by changing investor preferences and a growing demand for alternative credit sources. Increased scrutiny of traditional lending practices has led to a surge in interest for private credit, with investors seeking more flexible and tailored solutions.

Growing demand for private credit has resulted in a significant increase in deal volume, with a 25% year-over-year growth rate in 2022. This trend is expected to continue, driven by the need for more customized financing solutions.

Investors are increasingly seeking private credit investments that offer higher yields and lower correlation to traditional assets. This shift is driven by the desire for more diversified portfolios and the need to mitigate risk in a low-yield environment.

The private credit market is a diverse and complex landscape, with various types of investments catering to different needs and risk appetites. Direct lending is one such type, where lenders provide credit to private, non-investment-grade companies.

Direct lending strategies often invest in the senior-most part of a company's capital structure, offering steady current income with relatively lower risk. The average direct lending deal size in 2023 was around $170 million, well below the traditional $500 million minimum thought required for the broadly syndicated loans market.

Direct lending has grown significantly over the past decade, with more entrants and larger fund sizes. However, this growth has also led to rising competition and stagnant direct lending volumes in 2023.

There are also junior capital instruments, which provide borrowers with subordinated debt that ranks below more senior loans for repayment in the event of a default or bankruptcy. These instruments often come with equity "kickers", which can support attractive total returns.

Junior capital includes mezzanine, second lien debt, and preferred equity, all of which are highly specialized and require a deep understanding of the company's financial situation. Distressed debt is another type of junior capital, which lenders use to support companies in financial distress through operational turnarounds and balance sheet restructuring.

Special situations are a fourth type of private credit, which involves non-traditional corporate events that require a high degree of customization and complexity. This can include companies undergoing M&A transactions, divestitures, or spinoffs.

Related reading: Marketing Companies Worth

Here are the four common types of private credit, listed out for easy reference:

In the private credit market, opportunities abound for investors willing to take on a bit more risk. Higher capital requirements and asset quality concerns have reduced banks' ability to conduct certain types of business, creating a fertile environment for private credit funds.

Many banks are looking to reduce risk exposures, which lowers competition in areas like corporate and real estate lending. This is creating new opportunities for investors in risk transfer deals.

Some potential solutions for borrowers struggling to find sustainable capital structures include adding subordinated debt with a payment in kind (PIK) feature or replacing existing debt with lower coupon substitutes that offer the lender equity upside through features like warrants.

Here are some key areas to consider:

Business Development Companies (BDCs) are a type of investment vehicle created to stimulate lending to small companies. They can be either public or private, with liquidity for private versions typically available at set intervals and subject to certain limits.

Public BDCs charge higher fees and their prices can diverge significantly from the underlying Net Asset Value (NAV), making them less attractive to many Limited Partners (LPs). Private BDCs, on the other hand, offer periodic liquidity and are more targeted at institutions and high-net-worth channels.

Some public BDCs trade below NAV, offering an opportunity for investors to generate above-coupon returns when discounts close. This was the case in 2023, with the S&P BDC Index returning 28% and bringing its five-year annualized return to more than 13%.

Institutional investors may be offered attractive terms, such as lower fees and management fee sharing, to help launch new private BDC vehicles.

A different take: Private Equity Returns vs Public Markets

Credit opportunity funds are a fertile ground for investors, particularly in a market where some borrowers need help finding more sustainable capital structures.

The median CCC-rated issuer doesn't have enough cash flow to cover its interest expense, and B-rated issuers, which account for a record high percentage of the high-yield and loan markets, are also operating on shakier ground.

Check this out: High Limit Credit Cards for 650 Credit Score

Private credit firms have stepped in to fill the gap in fund finance, a market that's currently estimated to be around $100 billion in value and expected to grow rapidly.

Investors in credit opportunity funds should consider the strength and resources of the overall platform, as specialized legal and accounting expertise will be required to supplement the ability to buy and sell CUSIPs.

Loans against fund NAV tend to have low loan-to-values (LTVs) and seniority in terms of other distributions to both LPs and the GP, making them an attractive option for LPs.

Investors are facing a unique set of challenges in the current market, but this also presents opportunities for those who know where to look.

Higher capital requirements, asset quality concerns, and competition for deposits are significantly impacting bank business models, reducing their ability to conduct certain types of business.

Many banks are looking to reduce risk exposures, which lowers competition in areas like corporate and real estate lending and creates new opportunities such as risk transfer deals.

Recommended read: Do Business Credit Cards Pull Personal Credit

Direct lending has outperformed in high and rising rate environments, yielding average returns of 11.6% compared to 5% for leveraged loans and 6.8% for high-yield bonds.

Private credit may also offer better mitigation against losses, having demonstrated relative resiliency during the COVID-19 pandemic.

The median CCC-rated issuer doesn’t have enough cash flow to cover its interest expense, and B-rated issuers are also operating on shakier ground.

Credit opportunity funds are well-positioned to take advantage of this dynamic, providing immediate help to borrowers who need more sustainable capital structures.

Here are some areas where investors can find opportunities in the private credit market:

Risk Management is a crucial aspect of the private credit market, and Significant Risk Transfer (SRT) deals are a key risk management tool for banks.

Banks engage in SRT deals to reduce required capital amounts, while keeping loans and maintaining relationships with underlying borrowers.

Outstanding volumes of SRT deals grew from $25 billion in 2023 to $200 billion globally, and are expected to continue growing briskly.

Suggestion: Credit Risk Transfer Primer

By transferring risk to a Special Purpose Vehicle (SPV), banks can reduce their risk-weighted assets and lower the amount of capital they need to hold.

In a typical SRT deal, a bank transfers risk on a pool of loans to an SPV, which then purchases protection from a credit fund on potential losses.

The bank's capital required to be held falls as its risk-weighted assets shrink under two dynamics: the notional amount of assets falls, and the "risk weight" that drives capital requirements also falls.

For example, in a deal where the bank transfers risk on a $100 million pool, its risk-weighted assets fall from $100 million to $17.5 million, reducing capital requirements by 82%.

Readers also liked: Are Credit One Cards Good

Investors should carefully weigh opportunity costs, alpha, and liquidity premium when considering private credit markets. This involves assessing the potential gains versus inherent risks, such as forgoing active opportunities to trade and increasing the risk of not having enough liquid assets for spending needs.

Liquidity premiums have compressed in both public and private credit markets, with lower-quality segments facing elevated vulnerability to economic slowdowns and higher interest rates. This means that investors may not be getting the premium they need to compensate for the risks of investing in private markets.

The cost of providing liquidity is estimated to be around 200 basis points (bps) a year, including the cost of lost alpha from active management of fixed income portfolios, the cost of the inability to rebalance portfolios, and the cost of liquidity shortfalls for unexpected liquidity needs.

The liquidity premium in investment grade segments of private credit markets has tightened to less than 100 bps, which is insufficient relative to opportunity costs associated with rebalancing, lost alpha from public fixed income, and potential costs of cash shortfalls.

Investors should consider the following key points when evaluating private credit markets:

By understanding these investment considerations, investors can make more informed decisions about whether private credit markets are a good fit for their investment goals and risk tolerance.

Higher capital requirements are forcing banks to reduce risk exposures, creating new opportunities for private credit funds. This is particularly evident in areas like corporate and real estate lending, where banks are looking to minimize their risk.

Banks are looking to reduce risk exposures, which is lowering competition in certain areas of lending. This is a result of increased regulatory scrutiny following the Global Financial Crisis.

Some banks are concerned about US commercial real estate loans and are reevaluating their lending strategies. This concern is a more recent development, dating back to the March 2023 US banking crisis.

Funding pressures following the March 2023 US banking crisis are also contributing to banks' desire to reduce risk exposures. This is creating new opportunities for private credit funds to fill the gap in areas like corporate and real estate lending.

Risk transfer deals are emerging as a new opportunity for private credit funds to take on risk that banks are seeking to avoid. This is a result of banks looking to reduce their risk exposures and lower competition in areas like corporate and real estate lending.

Public bond market liquidity has diminished, with a reduction in the supply of bonds held by primary dealers, but this doesn't necessarily mean liquidity has evaporated.

Some argue that liquidity in public corporate credit markets has decreased, particularly outside of the largest issuers, but this is an inaccurate assessment.

Trade volumes indicate that liquidity is abundant in high-quality public credit markets, with average daily trading activity for U.S. dollar investment grade bonds reaching $34.8 billion as of June 25, 2024.

A small percentage of investment grade bonds don't trade each month, suggesting that liquidity is not a significant concern in this market.

A unique perspective: Trade Credits

Private credit has historically offered compelling performance in relation to other segments of the fixed-income market. Since the global financial crisis, direct lending has provided higher returns and lower volatility compared to both leveraged loans and high-yield bonds.

Direct lending has outperformed in high and rising rate environments, yielding average returns of 11.6% over seven different periods between the first quarter of 2008 and the third quarter of 2023. This is significantly higher than leveraged loans at 5% and high-yield bonds at 6.8%.

Direct lending has also demonstrated relative resiliency during the COVID-19 pandemic, sustaining losses of only 1.1% between the outbreak of COVID and the third quarter of 2023. This is a lower loss rate compared to leveraged loans at 1.3% and high-yield bonds at 2.2%.

Take a look at this: Higher Credit Limit Cards

Public bond market liquidity has diminished in some traditional measures, such as a reduction in primary dealer inventories. However, this doesn't necessarily mean liquidity has evaporated.

The primary dealer relationship has become less essential due to technological advances like exchange-traded funds (ETFs) and all-to-all trading. This allows investors to trade directly with each other without going through a primary dealer.

Trade volumes indicate liquidity is abundant in high-quality public credit markets. In fact, average daily trading activity for U.S. dollar investment-grade bonds in 2024 is $34.8 billion as of June 25.

Only a small percentage of investment-grade bonds don't trade each month.

Private credit markets offer an excess premium of about 200 basis points to compensate investors for potential lost alpha and opportunity costs. This premium is a result of the structural differences between public and private credit markets.

Investors who opt for private markets give up near-term liquidity in pursuit of a liquidity premium over a longer horizon. However, the liquidity premium in many areas of private markets has tightened to unattractive levels.

Take a look at this: Emerging Markets Private Equity

Private credit markets offer superior documentation through the sponsor-lender relationship or structural seniority through asset coverage, which can limit downside risk if credit deteriorates. This is a key advantage of private credit markets over public markets.

The liquidity premium has compressed in both public and private credit markets, with lower-quality segments of each facing elevated vulnerability to economic slowdowns and higher interest rates. Public markets offer opportunities to pivot to more attractive sectors.

High-quality, liquid public fixed income can offer attractive yields and serve as a hedge against risk assets. It's essential to consider the significant repricing in rates globally and the value that can be found in these areas.

Investors should consider changes in valuations and market structure across private and public fixed income markets in recent years while making allocation decisions.

Here are some key areas to focus on in private credit markets:

These areas offer tremendous value today, with attractive yields and the potential for limited downside risk.