Private Credit: Dispelling the Myths

Introduction

The growth of private credit over the past decade has been nothing short of extraordinary. According to Preqin, private credit markets now comprise roughly US$1.5 trillion of assets under management (AUM) across business development companies (or BDCs, which commonly provide capital for small and medium-sized businesses in the US), funds and other vehicles. The market grew at a compound annual growth rate (CAGR) of 17.5% from 2016 to 2022 and is forecasted to grow at a CAGR of 11.1% from 2024 to 2028.¹

While some headlines have celebrated the rapid growth of the asset class, others have sounded the alarm about the potential risks. These conflicting messages can create confusion for investors and regulators, making it hard to distinguish between fact and noise.

This paper seeks to tackle some of the key myths and misconceptions about private credit, offering practitioners’ insights for investors exploring this burgeoning asset class.

Defining private credit – getting our terms straight

Before diving in, we think it’s worth defining what constitutes the private credit universe. Across news articles and analyses alike, we have noticed a lack of consistency around how private credit markets are defined and this has muddied the debate.

We view private credit as a sub-segment of the wider leveraged and acquisition finance (LAF) market, which includes high yield bonds and leveraged loans. The Alternative Credit Council (ACC) describes private credit as an ‘umbrella term’ encompassing the provision of credit by non-bank lenders.² Asset-management companies, mainly regulated firms, make up the most common type of private-credit lender. Asset managers act as the general partners (GP) of funds that pool capital from various types of investors and, in turn, the funds act as lenders to various borrowers. Today, the ACC estimates the global private credit universe is approximately US$3 trillion in size, underscoring the increasing importance of the asset class in providing funding to the global economy.

In the period around the Global Financial Crisis (GFC), investors and private credit professionals often used the phrase ‘direct lending’ interchangeably with ‘private credit’. Today, although most of the capital in private credit funds are still deployed in the form of directly originated loans to corporate borrowers, other sub-strategies under the private credit umbrella have also grown and come into their own.

These growing sub-strategies include lending to non-corporate borrowers, such as private real estate debt, asset-based lending and structured products (where the underlying assets are private loans to corporate and non-corporate borrowers), as well as partnerships with banks, such as credit risk sharing (CRS) and significant risk transfer (SRT), which we will discuss in further detail later. Despite the broad range of borrower types and vehicles employed, these strategies share some key characteristics, which include:

• Lack of secondary market liquidity: Unlike publicly traded assets, such as equities or bonds, private market investments are not easily traded on open exchanges. Private market transactions typically involve bespoke agreements, limited buyer pools and time-intensive due diligence, making it more difficult to buy or sell these assets quickly. The lack of a secondary market and the consequent inability to exit investments also underscores the importance of making judicious and well-informed investment decisions
• Buy-and-hold investment approach: Private markets typically involve investments with a lock-up period. This is a deliberate approach to generate value over time, as one of the most valuable lessons learned from the GFC was the importance of matching the duration of assets and liabilities. The typical length of the investment period in private credit ranges from three to seven years, depending on the duration of the underlying assets. In return, investors may benefit from a yield pick-up as they capture the illiquidity premia
• Sourcing investments is a key source of alpha: Private markets operate with less transparency than public markets, limited deal flow and highly fragmented information. Given that many private credit borrowers are smaller and issue smaller loans, private loans typically have no public bond ratings, although many are privately rated. This creates significant opportunities for alpha generation for those with the ability to identify, access, analyse and act on high-quality opportunities

With that cleared up, let’s jump into our first myth.

Myth 1: Investing in private credit is a zero-sum game between banks and non-bank lenders

As we have outlined above, today’s private credit ecosystem is complex, comprising private equity fund managers, non-bank financial institutions (NBFIs or private credit) and banks. The dominant narrative has broadly positioned non-bank lenders in direct opposition to banks. We believe this framework is too simplistic and confuses the issue. Roughly half of the capital lent to corporate borrowers who take on debt to fund acquisitions or other corporate transactions through NBFIs is provided by the banking system via various forms of fund finance. Banks have participated in the expansion of the private credit market by providing low-cost funding and mitigating the negative impact of stricter capital requirements by lending to specialised NBFI lenders, as well as by providing leverage to private credit funds.

In today’s lending ecosystem, banks and private creditors have found a way to peacefully and profitably co-exist. Naturally, there is, and will always be, a level of competitive tension. Some banks are still lending to smaller borrowers in the middle market (typically defined as borrowers with less than US$75 million annual earnings before interest, taxes, depreciation, and amortisation (EBITDA)), although the consolidation we are seeing in the banking industry, as well as continued regulatory pressures, have continued to weigh on banks’ ability to own credit risk on their own balance sheets.

In an ideal world, private lenders would focus on their relatively low leverage and stable capital bases to take incremental risk, while the banking system would look to leverage its very low cost of funds and implicit leverage to lend to low-risk borrowers or those with substantial subordinated capital beneath them. And for the time being, that is exactly what is taking place.

Myth 2: Private credit is a new, untested strategy

Market commentary over the past few years would have one believe that private credit is a new and untested strategy. In reality, NBFIs pre-date formal banks by roughly 5,000 years. Depository bank lending is thus, in the wider arc of financial history, a relatively new innovation compared to NBFIs.

The inception of private credit dates back to the early 1980s, as insurance companies and specialty finance companies made loans to companies and borrowers that were underserved by the banking system. The private credit market saw an increase in growth after the 2008 GFC, when an increase in banking regulation gave rise to strategies like direct lending (where non-bank lenders step into the void as an alternative to bank lending), as well as strategies like SRT (whereby private investors work in partnership with banks in a set of synthetic or cash securitisations that help banks to manage the risks in their portfolio). SRTs have existed in banks’ risk management toolkit since the 1990s, and are subject to a wide set of regulations, including internal controls. In 2023, the Federal Reserve explicitly stated in its frequently asked questions that SRT serves as a credit risk mitigant for banks.³

In short, the private credit universe has undergone a significant evolution over the last few decades, but many of the underlying strategies have existed for many years and are not as newfangled as some commentators would have you believe.

Myth 3: Private credit is the cause of significant systematic risk to the global financial system

The pace of growth over the last two decades could lead one to believe that non-financial corporations are borrowing recklessly. When viewed in the context of broader credit markets, however, it is notable that non-investment grade (IG) credit as a percentage of the overall credit market has been broadly stable for more than a decade, as shown in Figure 1 below.

Figure 1: Non-IG credit as a proportion of total credit has been broadly stable

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Source: PitchBook, as of June 2024.

Given the faster growth of private credit relative to the overall credit market and the similar rate of growth of LAF and IG markets, this means that private credit is taking share from the other sub-strategies in the LAF market. Indeed, Figure 2 shows how private credit and leveraged loans are taking considerable share from the high yield bond market.

Figure 2. Private credit and broadly syndicated loans are taking considerable share from high yield bond market

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Source: PitchBook, as of June 2024.

Furthermore, despite the headlines on the risks associated with private credit, areas of direct lending such as lower and core middle market lending have continued to employ maintenance covenants. An example of a key maintenance covenant is the leverage covenant, which measures the ratio of leverage to EBITDA. Furthermore, many direct loans to smaller borrowers continue to impose specific caps on EBITDA adjustments, defining and limiting actions such as add-backs to earnings.

Maintenance covenants were formerly the norm for leveraged loans but have been replaced by the less onerous incurrence covenants. Indeed, cov-lite loans represented approximately 93% of all US institutional leveraged loans issued in 2023.⁴ As the higher-for-longer interest rate regime and inflationary pressures continue to weigh on the US borrowers’ balance sheets, the latest statistics on private credit loans show a 1.7% payment default rate compared to a 4.5% default rate for leveraged loans.⁵ The final quarter of 2024 was particularly noteworthy for the volume of liability management exercises (LME) which took place in the leveraged loan market.⁶

Myth 4: Private credit is a 'beta' bet, with little to differentiate lenders

Direct lending is the most developed sub-asset class in private credit and for many institutional investors, it no longer sits in the niche or satellite part of their portfolio but has rather become a core part of their fixed income allocation. As familiarity with the asset class grows more broadly, we are seeing a narrative emerge that all direct lenders are alike. We believe this view is misinformed for several reasons.

First and foremost, as the direct lending universe has grown, we have seen increased bifurcation based on borrower size. In the upper middle market, the largest borrowers are pitting private credit lenders against the broadly syndicated loan market, resulting in fierce competition and driving spread compression and the loosening of lending terms. In contrast, greater inefficiencies in lending to smaller borrowers and stronger covenants have supported a trend of relative outperformance and lower defaults in the core middle market.

Further, investors have had a decade of largely benign credit markets, potentially lulling them into a false sense of security that credit selection no longer matters. The era of easy money is over, in our view, however. As a result, we expect credit provision to be tighter and we also expect to see greater differentiation across credits and managers. Using the BDC peer universe as a case study, we see a significant bifurcation in portfolio performance as measured by exposure to payment-in-kind (PIK) loans. While there is no single metric that fully illustrates the performance of the portfolio, a loan with a PIK feature usually indicates that a borrower is having liquidity challenges and is unable to meet its interest obligations in cash. As of December 2024, the BDC peer universe shows exposure to PIK loans ranging from 4% to 16%, indicating a meaningful difference in underwriting quality.

Against this backdrop, careful credit selection, structuring and portfolio risk management, as well as direct contact with sponsors and company management, will continue to be key drivers of performance.

Myth 5: All private credit offers is subordinated capital

There is a misconception that private credit is particularly risky, and a part of that misconception is that private capital is only there to fund the least creditworthy borrowers and the riskiest part of the borrower’s balance sheet. This overlooks the fact that a significant part of the private credit universe is investment grade rated.

Figure 3 shows a breakdown of private credit by strategy.⁷ Although direct lending to corporate borrowers is the largest segment of the survey correspondents, asset-backed lending (ABL) and private credit collateralised loan obligations (CLOs) represent a significant part of the growth in private credit. Much of the investor exposure to ABL and the private credit CLO universe comes in the form of cash or synthetic securitisation, where a majority of the capital stack is IG-rated. Furthermore, Figure 3 below understates the amount of non-subordinated capital in private credit. For example, in the SRT universe, the bilateral structure of the deals often offers the ability to structure non-subordinated capital.

Figure 3. Private credit by strategy

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Source: Financing the Economy 2024, Alternative Credit Council: www.lendingforgrowth.org.

Conclusion: A clear view into private credit

Private credit has experienced extraordinary growth over the past decade, but this has been accompanied by the emergence of several myths and misunderstandings about the asset class.

We have shown that the opposition set up between private credit and banks is overly simplistic, that the asset class has a much longer history than some commentators suggest and there is little evidence to back up the claim that private credit poses a systemic risk to the global financial system. To the contrary, some private credit strategies such as SRTs serve as a tool for banks to manage their credit risk, while others, such as direct lending, provide capital to underserved corporate borrowers in a less levered structure and in vehicles that can provide better asset-liability matching compared to banks.

Further, there is much greater differentiation between private credit managers than often believed. We expect this only to increase now that the era of easy money is over. Against this backdrop, careful credit selection will be more important than ever. We believe that a better understanding of the depth and breadth of private credit as an asset class can arm investors with a toolkit to help future-proof their investment portfolios.

1. Source: 3Q24 Private Credit Performance: Key Highlights and Analysis– Callan Associates.
2. Source: ACC.
3. Source: The Fed - Frequently Asked Questions about Regulation Q.
4. Source: Thomson Reuters Covenant-Lite Loans Overview, 2024.
5. Source: KBRA, Financing the Economy – ACC. JP Morgan Default Monitor, 1/3/2025 – figure for leveraged loans includes distressed exchanges.
6. Source: “Leveraged Loans Account for an Unprecedented 79% of 2024’s Total Default / LME Activity” – JP Morgan Default Monitor, 2 December 2024.
7. Source: Financing the Economy 2024, Alternative Credit Council. www.lendingforgrowth.org.