Private Credit - Part I

Part II will appear later this week. The full article can be found here. If you would like to read more about business transformation, restructuring, turnaround and value creation from a middle market perspective, visit and subscribe to Base of the Pyramid.

“Capitalism is the astounding belief that the most wickedest of men will do the most wickedest of things for the greatest good of everyone.”

-??????? John Maynard Keynes

Overview

The rise of private credit has been met by savvy market watchers with a combination of curiosity, relief, awe and disquiet. The curiosity arises as the asset class has grown to encompass an increasingly broad swath of lending activities. Relief emanates from those in the trenches, who are pleased to observe a growing number of savvy capital providers that are not only able, but eager to act quickly and provide bespoke financing to companies in need of capital. Awe comes into play when reflecting on the explosive growth in assets under management (see Exhibit A). As for disquiet, for those who reflect on economic history, it is easy to feel that something fundamental might be missing, and we might all come to regret the systemic changes that the growth of private credit has brought and will continue to bring to the market.

This post is intended to be a deep dive into the nature of private credit and an exploration of how the rise of this asset class has impacted and will continue to impact the lower middle market. I will cover the evolution of the asset class, discuss and interrogate the stated benefits, examine the ways in which private credit is altering and will continue to alter the restructuring ecosystem, and close with an overview of the current market and clear trends as they apply to the lower middle market. For this article I lean heavily on the excellent scholarship of Jared A. Elias (Harvard University) and Elizabeth de Fontenay (Duke University) in their working paper “The Credit Markets Go Dark”. Unless otherwise noted, facts and definitional elements come from this piece, and discussion will be limited to the U.S. market.

For simplicity, and to minimize confusion when writing about a rapidly growing and evolving asset class, I will adopt the definition of private credit that Elias and de Fontenay employ. That is, private credit will here be defined as an asset class whereby investment funds originate, fund, and seek to hold to maturity loans to companies.

Exhibit A: Private Credit Assets Under Management

The Evolution of Private Credit

Private credit, prior to the Global Financial Crisis (GFC), existed, but on the (oftentimes extremely profitable) margins of the lending universe. Prior to the 1990s, both large and small firms primarily had their lending needs met by banks, which provided loans on a secured basis. However, starting in the 1990s and accelerating thereafter, the lending market bifurcated. For small and midsized companies, relationship lending (see Exhibit B) persisted as the dominant model for financing, whereas for larger companies syndicated lending became the standard (see Exhibit C). Post-GFC, increasing regulatory pressure to de-risk the banking sector led to a shift in lending away from banks and provided the nascent asset class with its opening.

An interesting aspect of the rise of private credit is that the debtor-creditor relationship structure is most similar to the relationship banking model, with private credit lenders in the role previously occupied by banks. Small and midsized companies have long been accustomed to working with a single lender, and while private credit lenders have different capabilities, incentives, and structural preferences than banks, the mechanics of having a single powerful lender to deal with may prove to be less jarring to small and midsized companies than it will be to their larger brethren, for whom syndicated lending delivered a world of diverse lenders overseen by a lead arranger (during structuring) and then an administrative agent (for the duration of the loan).

Any discussion of private credit and its rise must acknowledge the boost that the asset class received from central banks and regulatory bodies. A period of extraordinary easing (zero interest rate policy, quantitative easing, etc.) created a massive tailwind, holding down the cost to debtors of the risk premia necessitated by private credit’s structure, and increasing the demand among investors for asset classes offering those return premia. Simultaneously, regulations shifted the incentives of banks, further accelerating this massive change in the lending ecosystem.

Exhibit B: Relationship Lending

Exhibit C: Syndicated Lending

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Part II will appear later this week. The full article can be found here. If you would like to read more about business transformation, restructuring, turnaround and value creation from a middle market perspective, visit and subscribe to Base of the Pyramid.

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