Private Credit

Private credit funds offer traditional public fixed income investors a means to significantly expand their investment opportunity set and and potentially enhance the yield profile of their portfolios.

Investing in private credit has grown in relevance over the past couple of decades as the market has grown from roughly $100 billion of assets under management in 2005 to over $1.7 trillion at June 2023. It is expected to surpass $2 trillion by 2028. The growth of this market has been fueled by two key drivers: (1) the reduced participation of banks in the middle market loan market (Fig. 1 LHS), and (2) the rapid growth of the private equity industry and the associated need to finance their transactions (Fig. 1 RHS).

Figure 1. LHS: Reduced participation of banks in loan market, RHS: Growth of private equity industry

Prior to the Great Financial Crisis, banks were the primary lenders to mid-sized private businesses in the U.S., but as bank consolidation and regulation has increased, they have pulled back lending and have been replaced by non-bank lenders such as asset management firms and insurance companies.

At the same time, the number of private equity owned companies in the U.S. has increased tenfold (Fig. 2 LHS). The demand for private capital solutions - both debt and equity - has grown from businesses who prefer to remain private, and work with a smaller number of active shareholders and credit solution providers. The supply of private capital from investors (initially from large institutions and now from individual investors) has also increased to meet this demand. On the credit side, investors have been attracted by the strong absolute and risk adjusted yield properties of the asset class. 

Figure 2. LHS: growth of private backed companies, RHS: Price volatility and return statistics

The private credit market in the U.S. is largely focused on established mid-sized companies with $10 million to $1 billion in annual revenues. This segment consists of approximately 200,000 private companies that represent 1/3 of the private sector Gross Domestic Product (GDP).

Historically, private credit has outperformed high yield bonds and broadly syndicated loans (the closer public market equivalent) by 2.3% and 3.9% with less volatility. They are mostly sub-investment grade, high income investments that pay out quarterly distributions but don’t produce much capital gains. Private credit is also mostly floating rate, which means it is not subject to capital losses (or gains) as interest rates fluctuate. This offers an element of diversification relative to more traditional fixed rate forms of credit, which are more broadly held by investors than floating rate credit.

Excess returns here can be explained by the higher rates borrowers are willing to pay for the certainty and speed of execution that private credit funds provide versus traditional investment banking channels, which typically take more time, involve more third parties, and which may not come through when market conditions are challenging. Private lenders are also positioned to provide more bespoke financing solutions for a wider range of borrowers and demand stricter lender protections in the form of covenants. Private credit funds also typically use forms of leverage that are absent in traditional fixed income strategies.

The methodologies used to value private assets are generally less susceptible to short term swings in market sentiment that can drive higher price volatility in publicly traded assets. Private assets are valued much less frequently than their public equivalents, and often with a considerable lag.

Fundamental differences in the investment process combined with longer time horizons required to harvest the potential benefits of private market investments are all factors that contribute to an “illiquidity premium” investors in these strategies have generally earned in the past and continue to expect in the future.