Private Credit Grew Into a Trillion Dollar Market Nobody Marks Daily
Lending moved from banks toward investment funds after the post crisis rules made some loans expensive for banks to hold. The economics are straightforward and the valuation question is not.
What It Is
Private credit refers to loans made by investment funds rather than by banks, held to maturity rather than syndicated and traded. Borrowers are typically mid sized companies, frequently owned by private equity firms, that want financing without the disclosure and process of a public bond issue.
The market expanded enormously after the financial crisis, growing into a multi trillion dollar asset class over roughly fifteen years.
Why It Grew
The growth was substantially a regulatory consequence. Post crisis capital rules made certain loans expensive for banks to hold, since riskier assets require more capital against them. That reduced bank appetite for exactly the borrowers private credit funds went on to serve.
The demand side mattered too. Years of low interest rates left pension funds and insurers unable to meet return targets with government bonds, so an asset offering several percentage points more yield attracted substantial allocations.
Regulation did not eliminate the lending. It moved it from institutions that are supervised and marked to institutions that are neither.
The Genuine Advantages
The structure has real merits and it is worth stating them fairly. A single lender can negotiate directly with a borrower, which means faster execution and terms tailored to the situation. Borrowers value the certainty and the confidentiality.
Funds also hold to maturity with locked up investor capital, so they are not forced sellers during a market dislocation. A bank facing deposit flight or a mutual fund facing redemptions may have to sell at bad prices. A closed end credit fund generally does not.
The Valuation Question
The concern is that these loans do not trade, so there is no market price. They are valued using models incorporating credit spreads, comparable transactions, and the borrower's performance.
The result is reported returns that appear smooth relative to public credit markets. Some of that smoothness is genuine, reflecting the absence of forced selling. Some is a measurement artifact, since an asset not marked to a volatile market does not display volatility regardless of what its risk actually is.
Distinguishing the two is difficult, and the honest position is that the reported volatility of private credit understates its economic risk by some amount that nobody can precisely quantify.
What to Watch
Several features deserve monitoring. Payment in kind arrangements, where a borrower pays interest by adding to principal rather than in cash, can conceal stress since the loan continues to accrue income while no cash is received.
Weakening covenants are another. Competition among lenders during the growth period pushed terms toward the borrower, which means less early warning when performance deteriorates.
And a substantial share of borrowers carry floating rate debt, so the rate increases of 2022 and 2023 raised their interest costs directly. Interest coverage ratios across the asset class deserve attention for exactly that reason.
The Bottom Line
Private credit is bank lending relocated to funds that mark their own loans. The illiquidity premium is real and so is the possibility that reported stability reflects the absence of a price rather than the absence of risk.