December 1, 2023

Why Private Credit Is So Darn Popular

Yields are high, and well-fixed institutions back them, but what happens in a recession?

Reported by Larry Light

Art by Harry Campbell

Special Coverage

Private debt has been derided by some as “shadow banking,” because it is not sponsored by traditional, regulated lenders, and its operations and potential risks are opaque. Despite the sinister-sounding soubriquet, private lending is a lucrative opportunity that has grown in popularity among allocators since the global financial crisis of 2008 and 2009.

Nevertheless, there are downsides that few appreciate. A recession, continued high interest rates and the weak condition of some borrowers could propel a batch of loans into default, harming investors in the lenders.

Few are worried about such an outcome today. Private debt’s ascent has been tremendous, ballooning to $1.75 trillion globally (most of it in the U.S.) as of mid-2023, up from $280 billion in 2007, PitchBook stats show. Moody’s Investors Service estimates the asset class will hit $2 trillion in 2027.

The catalyst for private credit’s rise was the retreat of commercial banks from making many loans amid post-crisis regulatory clampdowns, which led to de facto loan bans on smaller businesses and those with lower credit scores. “The banking sector was done with them,” says Andrew Grant, manager of research and investment solutions at investment firm Kayne Anderson Rudnick, which furnishes investment strategy to allocators. “Someone had to fill the void.”

Deep-pocketed investment firms, among them private equity players on the order of KKR, Apollo and Blackstone, jumped on the chance to play banker without much Washington oversight. PE purveyors account for almost half of private credit’s assets. The most-used platform for private debt is a limited partnership or limited liability corporation, alongside such other vehicles as business development companies, which, unlike LPs, must disclose financial data.

Among U.S. and Canadian public pension plans, Preqin reported, private credit amounts to 3.8% of their portfolios. The capital raised to back private loans reached $172 billion in 2022, up from $61 billion in 2011, Preqin found. This fall, Blackstone reportedly raised $8 billion from institutions for one of its funds (Blackstone declined to confirm this).

The private loan providers found a willing investor base. Institutions have been happy to invest in private debt funds, providing 88% of those funds’ assets, PitchBook noted. The San Diego City Employees’ Retirement System exemplifies the trend: At the May meeting of its board of administration, the plan pledged to increase its allocation to private credit to 5% of its $10 billion-plus portfolio, up from zero before. “Timing is particularly attractive with this asset class,” the SDCERS CIO, Carina Coleman, told her plan’s board, as the yields are lush nowadays.

The Lure of Private Credit

As demonstrated by the San Diego plan, the higher interest rates kicking in over the past two years have been a spur to private lending. Private lenders can charge higher rates, often in the low teens, than traditional banks do (average: 7%), and those private rates often are floating, a boon for private credit and its investors amid higher interest rates lately.

Hence, the private debt crowd can boast superior returns to its investors. “This has been such a rapid shift” from the era of near-zero rates, remarks Miguel Sosa, head of market research and strategy at alternative asset manager Bluerock Capital Markets, which runs a private credit fund for institutions.

Further, loans often are packaged in collateralized loan obligations, or CLOs, which provide the protection of diversity for private debt issuers and their investors. Covenants for borrowers (conditions they must meet, such as maintaining a comfortable cash flow to make interest payments) usually are more restrictive than traditional alternatives.

Private lenders can afford to be picky regarding borrowers. Brian Gerson, head of private credit at asset manager FS Investments, a private lender, says his organization specializes in solid companies and demands to be well-positioned in the credit ranking. “We have 70% of them [the loans] first-lien,” he says, meaning they are the first in line to get paid if a borrower fails. At the moment, the default rate for private debt is low: just 1.4% in this year’s third quarter, according to the Proskauer law firm, which follows the space.

Tellingly, private debt has outperformed other alternatives in bad times, notably in snake-bitten 2022. Although stock and fixed-income investors suffered big losses of 18.1% on the S&P 500 and 15.7% on high-grade corporate bonds, private credit investment funds earned 4.2%, per PitchBook.

Although tallies are not in yet for 2023, PitchBook points to the Morningstar LSTA US Leveraged Loan Index, as a proxy for private debt. The Morningstar gauge is up 11.3% this year, besting the bond-tracking Bloomberg US Agg Total Return index’s 1.1% and trailing only the now-surging S&P 500, ahead 18.8%.

Private debt is a nice sideline for PE firms such as Apollo. While their fee-rich mergers and acquisitions action is down lately, the remaining buyouts are increasingly financed by private loans, not bank ones. The same is true for refinancing corporate debt, especially for junk-rated companies.

Commercial lenders are vulnerable to deposit flight, as was evident in the collapse of Silicon Valley Bank earlier this year. Investors in private credit funds, on the other hand, are the picture of patient, stable capital.

U.S. private and public pension systems hold almost one-third of private loan fund assets, or $307 billion, according to a Federal Reserve report. The same report contended that the size and sophistication of private credit fund investors offset the drawback of the sector’s lack of transparency.

What Could Go Wrong?

Some compare the current enthusiasm for private debt with the hoopla that fueled junk bonds in the 1980s. Those bonds also offered high yields and concentrated in companies that traditional investors found too risky. That all came crashing down early in the next decade, as too many junk-issuing companies could not service their considerable debts, and the nation endured a recession in 1990.

Similarly, the onset of a recession, the threat of which loomed larger earlier this year than it does now, would shake out some of the weaker credits, a Moody’s Investor Service research paper warned in June. “Higher rates, higher inflation, slower economic growth and a contraction in valuation multiples” would wreak havoc, it contended. The riskiest loans, Moody’s declared, are those made in 2021 in the market euphoria coming out of the pandemic. Covenants for these loans are notably weak, the agency stated.

No one can be sure when the next economic downturn will occur, and the consensus of late is that day is far off. Regardless of when it hits, a disturbingly large number of private lending creditors are at risk of default, a study by S&P Global Ratings found.

The agency ran stress tests on 2,000 corporate borrowers of private debt, using various scenarios. Should the economy go south, 54% would have negative cash flow under the mildest scenario. The report concluded that “we would expect to see a material pickup in defaults if interest rates remain high for a longer period.”

Although the S&P report did not specify what the default rate could climb to then, a separate estimate by Bank of America analysts put the number at 5% next year if interest rates remain high.

This baleful development would be painful for allocators and other large investors, but hardly ruinous. After all, junk bonds survived the early 1990 wipeout and now are an established asset class. Private credit, with its elite, well-funded backing, should take heart.