Private Credit Grew Into a Trillion Dollar Market Nobody Marks Daily

What It Is

Private credit refers to loans provided by investment funds rather than banks held to maturity rather than syndicated and negotiated. Borrowers are typically mid-sized companies often owned by private equity firms that want financing without the disclosure and process of a public bond issue

The market expanded greatly after the financial crisis becoming a multi-trillion-dollar asset class in about fifteen years

The defining characteristic is not the credit itself. Midsize business lending is an old business and the loans look a lot like what banks used to make. What's changed is who owns them how they're financed and whether anyone looks at a price. Those three differences explain almost all the arguments about the asset class

Why It Grew

The growth was substantially a regulatory consequence. Post-crisis capital rules made certain loans costly for banks as riskier assets require more capital to offset. That reduced banks' appetite for exactly the borrowers that private credit funds came to serve

The demand side also mattered. Years of low interest rates left pension funds and insurers unable to meet yield targets on government bonds so an asset offering several percentage points more yield attracted substantial allocations

A third driver was on the borrower's side and is easy to overlook. Private equity ownership grew over the same period and a fund-owned company needs debt on a schedule set by a transaction. It is worth paying more for a single lender that can commit to full financing in days without a qualification process or a syndication window when the alternative is losing the deal. Speed ​​and certainty were the product and the performance premium is partly the price of them rather than a compensation for the risk

How the Loans Are Structured

The structures are worth knowing because they determine how much protection you buy with performance

The common form is a section unit a single loan that replaces what would otherwise be separate senior and subordinated tranches priced at a blended rate somewhere between the two. It is simpler for the borrower and concentrates all exposure on one lender or a small group

Most of it is floating rate quoted as a spread over a reference rate. That protects the lender when rates rise since the coupon increases with them and transfers the risk directly to the borrower's cash flow

Deals reach borrowers through direct origination by the fund or through a small club of lenders rather than a broad syndicate. Loans are held rather than distributed so a fund's exposure to a bad credit decision is not sold to anyone else

The vehicles that hold these loans vary and the differences are important. Closed-end funds with locked-in capital have no repayment pressure. Business development companies are permanent capital vehicles some are publicly traded and some are not and those that are publicly traded trade at prices that can differ substantially from their own stated net asset value which is one of the few publicly available opinions on private credit brands

The Genuine Advantages

The structure has real advantages and are worth setting out fairly. A single lender can negotiate directly with a borrower which means faster execution and terms tailored to the situation. Borrowers value certainty and confidentiality

The funds are also held to maturity with locked-in investor capital so they are not forced to sell during a market disruption. A bank facing a run on deposits or a mutual fund facing redemptions may have to sell at bad prices. A closed-end credit fund generally does not

There is also a training advantage. A loan held by one lender can be restructured in one conversation while a syndicated loan spread among dozens of holders with different incentives requires a negotiation between the creditors before any negotiation with the borrower. Concentrated ownership is a genuine risk problem and a genuine benefit when a company needs its terms to change quickly

The Valuation Question

The concern is that these loans are not traded so there is no market price. They are valued using models that incorporate credit spreads comparable transactions and borrower performance

The result is returns that appear fluid relative to public credit markets. Some of that fluidity is genuine and reflects the absence of forced selling. Some are a measurement artifact since an asset that is not marked for a volatile market does not show 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 underestimates its economic risk by an amount that no one can precisely quantify

Who Decides What a Loan Is Worth

Since there is no price the interesting question is procedural: who produces the number and what would make it move

Servicers typically hire third-party valuation companies and vehicle boards approve the ratings. That's a real process and not the same as a marketplace. A valuation agent works with the same data that the servicer has and the biggest of that data is the borrower's self-reported performance which comes in quarterly and privately

What this produces is a brand that responds to credit events rather than sentiment. A loan to a company that meets its obligations tends to book at or near par regardless of what a comparable public credit is doing and moves when something identifiable happens to the borrower. Public credit prices vary continually even for reasons that have nothing to do with any individual borrower

Neither of them are right. A public price contains information that the private label lacks and also contains a lot of noise and the private label is stable in part because it is not asked the question every day. What can be said with confidence is that the two are not comparable measures and any exercise that places a private credit return series next to a public one and compares volatility or correlation is comparing measurement conventions

What to Watch

Several features are worth monitoring. Payment-in-kind arrangements in which a borrower pays interest by adding equity to the principal rather than in cash can hide stress as the loan continues to accrue income while no cash is received

Debilitating covenants are another. Competition among lenders during the growth period pushed terms toward the borrower meaning less early warning when performance deteriorates

And a substantial proportion of borrowers have floating-rate debt so the 2022 and 2023 rate increases directly increased their interest costs. Interest coverage ratios across the asset class deserve attention for exactly that reason

The floating rate feature is the clearest example of how a protection for the lender becomes a risk for the lender. A rising benchmark rate raises the coupon which is why the structure exists. It also raises the borrower's interest bill on a balance sheet that was sized by the previous rate and a company backed by its ability to pay debt at one rate level does not automatically pay it at another. The lender's income increases and the borrower's ability to pay decreases which is the same movement viewed from two sides

Two more are worth adding. The proportion of a fund's income that arrives as cash rather than accumulation since a portfolio that reports a healthy return while distributing little cash describes more than just health. And the proportion of loans that have been modified since a modification is the private market version of a downgrade and occurs without any public announcement

Who the Money Comes From

The character of an asset class is determined by who owns it and the holder base here has changed as it has grown

The original investors were institutions with really long horizons. Pension funds have decades-long liabilities and insurers have annuity obligations that must be combined with assets that produce predictable income which is a good fit for a loan portfolio held to maturity. For that type of holder illiquidity is almost free because they were never going to need the money ahead of time

The insurance channel became particularly important since an insurer that earns a spread between what it pays for annuity policies and what its assets yield has a direct business reason for wanting higher-yielding credit. Several large managers own or are affiliated with insurers for exactly this reason which puts permanent capital on the balance sheet rather than funding commitments with an end date

The most recent development is the push towards individual investors through vehicles that offer periodic liquidity rather than a complete lock-in. They typically allow quarterly redemptions and limit the amount that can be withdrawn in any period to a fraction of the fund's value

That cap is the whole design and it is worth understanding what it does. It prevents a run in the sense that the fund cannot be exhausted. It does not prevent the queue that forms when the limit is set and a vehicle that has reached its limit is a vehicle whose investors have learned that they cannot exit at will. The claim that private credit funds face no redemption pressure applied to the institutional structures upon which the asset class was built and is a claim about a legal document rather than the asset sowhich should be checked against any vehicle that is actually being purchased

The Question of Leverage

The loans themselves are just one layer and the layer above them changes the risk considerably

Credit funds often borrow to improve returns so an asset that generates a moderate spread over the benchmark rate can be converted into a substantially higher return on equity. That leverage is largely provided by banks which lend to the funds that replaced them as direct lenders

The consequence is that the risk did not leave the banking system but changed its position in the queue. A bank that previously held the loan directly now lends against a portfolio of similar loans backed by the fund's own capital. That is a better position for the bank than owning the loan outright and it is not an absence of exposure

It also creates the only plausible route to a fire sale in a structure designed to have none. A fund that never has to face repayments may have to satisfy a demand from its own lender if the value of its collateral falls enough. Lockup protects against investors asking for their money back. It does not protect against a lender's demand

What Would Actually Test It

The asset class has grown almost entirely over a period without a broad corporate default cycle. That fact determines how much weight its track record can carry and it deserves to be mentioned before any of the performance numbers

The claims made in this regard are plausible and mostly untested at scale. Concentrated ownership should speed up restructurings. Locked-up capital should prevent forced sales. Direct origination should mean better underwriting than a syndicated market where the originator spreads the risk

Each of them would be demonstrated by a wave of actual defaults and nothing more. The evidence now available is a record of returns produced under conditions that were favorable for lending to leveraged companies valued through a non-market process during a period in which very few borrowers failed

That's not an argument that the asset class is bad. It's an argument for reading performance as compensation for as-yet-unobserved risk rather than as an earned and proven premium and for treating the fluidity of the reported series as the least informative about it

The Bottom Line

Private credit is bank loans transferred to funds that mark up their own loans. The illiquidity premium is real and so is the possibility that the reported stability reflects the absence of a price rather than the absence of risk. The structure has real advantages in speed security and training and has grown fully in conditions that have not yet been tested by any of them. Questions worth asking are how much of the income comes in cash how much leverage there is on the loans and who would have the right to demand repaymentof money if the marks fell