Long the domain of banks, private credit has exploded in the past decade with the U.S. private credit market reaching an estimated $2.1 trillion as of 2023. Today, the private credit market is comparable in size to the more liquid broadly syndicated loan market and the high yield bond market. Each of these markets provides capital to companies that have lower credit ratings (and a higher expected risk of default) than investment grade borrowers and provides investors with nominally higher rates of return.
While many factors have driven the growth in private credit over the past few decades, a fundamental shift in the regulatory environment for global banks that started in the late 1980s has led to banks significantly reducing their share of the overall market for leveraged loans. This trend accelerated after the 2007 – 2008 global financial crisis (GFC) as bank lending activities were curtailed through increased regulation and compliance. The structural shift away from bank lending is evident in the following chart from the Federal Reserve Bank of New York which shows all loans as a percentage of total bank assets sliding from over 60% in 1990 to about 45% today, and the largest decline occurring with Commercial & Industrial Loans.
Loans as a % Total Assets
For mostly larger companies seeking capital, the high yield and broadly syndicated loan markets attracted capital from institutional and retail investors to fill the void. For smaller companies, the direct lending market led by private fund managers, business development companies, and interval funds provided an alternative source of capital. Initially, those managers sold their products primarily to large pension plans, sovereign wealth funds, and insurance companies searching for higher yields in their investment portfolios. More recently, individual investors have increased their share of the direct lending market as the prospect of higher returns and greater diversification has attracted them. In some respects, the democratization of private markets has been most evident in the private credit markets as investors of all types relentlessly searched for yield during the persistent low-interest rate environment of 2009 to 2022.
In this article, we look at the regulatory environment for banks and the impact it may have on creating opportunities for investors in growing segments of private credit. We also look at how individual investors can evaluate fund offerings as they become available like direct lending funds have increasingly targeted retail investors.
Growth in Traditional Private Credit
Growth in private credit has been driven by the confluence of factors over an extended period dating back to the early 1980s. The expansion of mergers & acquisitions and the creation of the high yield bond market led to a significant increase in leveraged lending by banks and other entities. The creation of Collateralized Loan Obligations and similar securitization structures in the late 1980s further spurred leverage lending and brought in a wider range of investors as loans were aggregated and sold in pieces to different investors. During this period, private equity was growing rapidly, and managers were funding acquisitions with significant amounts of leverage. Concurrently, there was significant consolidation among the larger commercial banks that serviced the LBO market. In 2013, concerned with the amount of risk banks were taking in their loan portfolios, U.S. bank regulators (the Federal Reserve (Fed), Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC) (collectively, the “regulators”) provided guidance to limit leveraged lending by banks. As banks partially withdrew from the leveraged loan market, non-bank lenders such as private credit funds, business development companies, and others filled the gap and grew with the expanding private equity market.
The effects of all of these factors are presented in the chart below from the Federal Reserve. Total private credit assets under management have grown by approximately 12x (or about 15% per annum) over the 17-year period 2005 – 2022. The market has continued to grow in 2023 and 2024.
Global Private Credit Assets Under Management
Increased Regulatory Scrutiny Redefining Private Credit Opportunities
With increased scrutiny on U.S. banks by the Fed and other regulators regarding bank loan portfolios, we may see a continued shift in investment opportunities going to private funds. For example, in July 2023, the Fed, OCC, and FDIC proposed changes to U.S. bank capital rules to meet the global standards known as Basel III, which were adopted in 2017. While there is great uncertainty as to which of the regulators’ proposals make it into the final rules, and the timing of adoption of final rules, there is a clear intent to require banks to hold more capital against credit, market, and operations risks.
Depending upon the outcome of the regulatory tightening, significant volumes of loans remain on bank balance sheets which may shift to private funds and other institutional investors. As of June 2024, U.S. commercial banks still hold approximately $2.8 trillion of commercial & industrial loans, $3.0 trillion of commercial real estate loans, and $1.9 trillion of consumer loans. Even without new regulatory standards, over the past 1 ½ years, banks have been selling portions of the performing and non-performing loan portfolios to reduce risk and build liquidity.
The following chart created by the consulting firm Oliver Wyman provides a good visual presentation of the different waves of disintermediation faced by banks over the last 50 years and the next one which has just begun impacting commercial mortgage loans and consumer and commercial finance.
Expansion of Private Credit Sector
Commercial Real Estate (CRE) Loans
Despite a substantial decline in real estate lending during the GFC which saw aggregate commercial mortgage loans held by U.S. banks decline by over 16% (from $1.7 trillion to $1.4 trillion), the market has steadily recovered. Over the last 11 years, bank loan balances have more than doubled to $2.9 trillion.
Throughout this period, banks have maintained a market share of about 50%, well above Fannie Mae & Freddie Mac (15%), life insurance companies (12%), and the CMBS market (10%). Today, the aggregate size of the market is estimated to be about $5.5 – 6.0 trillion.
During the GFC, the CRE sector faced a wave of maturities that needed refinancing. With the demand for debt capital high and banks constrained through new regulations, private fund managers stepped into the void with aggregate capital raised peaking in 2021 at $42 billion before interest rate increases damped capital raising and new fund formation. Despite the increase in fundraising, private funds still only account for about 5% of the market.
The CRE loan market is at a juncture where private credit funds may start to gain meaningful market share. Post-COVID, banks have experienced deteriorating loan portfolios due to hybrid work stressing office properties and much higher interest rates than when loans were issued. Much like the period post-GFC, there is a significant amount of mortgage loans maturing in the next three years that need to be extended or refinanced. At the same time, regulators and rating agencies are scrutinizing bank loan portfolios, and we see that banks are tightening their credit underwriting and selling part of their portfolios to reduce their exposure to the sector.
Asset-Backed Financings
Asset-based finance (ABF) is a form of lending for consumers, companies, and others. Typical consumer loans include residential mortgages, automobile loans, credit cards, and student loans. Typical commercial finance includes equipment leasing, aircraft leasing, rail cars, and accounts receivables). Others can be a broad range of transactions ranging from royalties on pharmaceuticals and music to sports broadcasting rights.
The private global ABF market is estimated to be $5.5 trillion, with 54% of the loans held by banks, 29% by specialty finance companies, 12% in public securities, and about 5% ($200 – 300 billion) by private credit funds.
Private fund managers see an extraordinary opportunity to fill a gap they expect to be created as banks retrench their lending. Many of the large U.S. private asset managers have been significantly growing their origination and underwriting teams to meet the expected demand. Since many of the large private asset managers also own insurance companies, it’s not yet clear how much of their push into ABF is to satisfy the need for higher yields on their insurance company assets versus the demand from institutional and high-net-worth investors. However, we have already seen one of the managers (Blackstone) announce the formation of a new interval fund that will invest across different private credit asset classes, including asset-based loans.
From Complexity to Clarity: Making Informed Choices in Private Credit
Similar to how large institutional investors have built specialized staff to invest in the different private asset classes, many have, or will, build specialized staff for the different segments of credit. This is not possible for smaller institutions with limited resources, or individual investors. Nevertheless, smaller institutions and individuals can apply principles developed and adhered to by sophisticated institutional investors to select the best private funds for their investment portfolios.
Investing in private assets often involves accepting illiquidity in exchange for potentially higher returns and diversification. While the risk of illiquidity may be lessened for fixed-income securities that generate periodic cashflows, it is important to know how long you will be locked into a private fund, as many funds recycle those cashflows and do not distribute them to investors for several years. Accordingly, you should determine what premium you are being paid for being illiquid by comparing the fund against publicly traded securities with similar risk characteristics. Measure this tradeoff against your personal financial situation and risk tolerance.
Key Areas for Due Diligence: The Product and the Manager
Understanding the Product
- Risk Assessment: Clearly determine where a fund sits on the risk spectrum. Are you investing in senior loans, junior loans, or equity-like instruments? Consider whether the fund is sector-focused and evaluate the volatility of that sector. Size and maturity of the underlying portfolio companies are additional determinants to consider.
- Duration and Interest Rate Risk: Apply the basic principles of fixed-income investing by examining the duration of a fund’s assets and interest rate risk. In doing so, you should look through the fund structure itself and at the underlying loans. For example, while a traditional private credit fund may have a 5-year duration because proceeds from maturing loans are reinvested in new loans, the underlying securities are floating rate loans with a typical duration of 1 or 3 months. There will not be much movement in the fund’s value due to interest rate (or spread) changes, but the yield will move accordingly. A similar 5-year fund investing in long-term aircraft leases, however, may generate consistent income, but its value will move as interest rates and spreads move.
- Collateral: Scrutinize the underlying assets in a fund. Don’t assume a secured loan portfolio is inherently “safe.” There are significant variances in the value of collateral, particularly in times of economic distress. Traditional collateral such as accounts receivable and inventory often retain substantial value, but they usually only secure a small percentage of the total loan amount in corporate transactions. Hard assets like real estate again may retain significant value, but past cycles have demonstrated that they are, at times, insufficient to cover their debt. Understanding how diversified a collateral pool is (geographic, asset type, etc.) is also important in assessing risk of loss.
- Leverage: Recognize that leverage can amplify both gains and losses and make fund returns more volatile. Assess whether a fund employs a prudent amount of leverage appropriate to the underlying asset risk and is not over-leveraged such that it cannot survive a severe credit cycle.
Evaluating the Manager
For all private funds, who the manager is matters a lot. While there has not been much academic research on the performance of private credit funds, there is some evidence of significant dispersion in returns of funds, which highlights the importance of manager selection.
- Experience Through Cycles: Gauge how much experience a manager has investing through credit cycles as well as their strategies and resources to preserve the value of their portfolios during difficult economic times. Since we have experienced a strong economic cycle in the U.S. for most of the last 15 years or so, many fund managers may have only operated during the “good times,” and some may not be equipped to make the tough decisions lenders need to make. For example, in our experience, one of the most difficult decisions a private credit manager must make is whether to financially support a portfolio company if the equity holders step back. Making the right decision can have a large payoff. Managers who can skillfully assess company situations and strategically invest when opportunities arise can generate outsized returns compared to others.
- Strategy and Execution: Delve into how the manager executes their strategy. As the private credit sector is highly complex and fiercely competitive, managers should be questioned about their competitive advantages in sourcing transactions, underwriting loans or structured products, and monitoring loan portfolios. Indicators like a diverse deal pipeline and a strong track record in minimizing loan losses can signal a manager’s effectiveness. Diversity of deal sources can demonstrate broad market reach, allowing a manager to develop a wide funnel of potential transactions to choose from. Loan loss experience provides a gauge of overall risk taken by a manager to achieve their historical returns.
By focusing on these key areas – understanding the product and scrutinizing the manager – you can confidently navigate the complexities of private credit investing and take advantage of the opportunities presented by this dynamic market.
“The Whole of the Moon” – The Waterboys
Despite its significant growth to date, we are still in the early days of expanding opportunities for private credit. This is a great time for small institutions and individual investors to start developing a thesis on which strategies are most suitable for their investment portfolios, how to access the strategies, and how to evaluate the managers. New opportunities in private credit have many years of runway and there will be plenty of time to invest – avoid the “fear of missing out.”.
Navigating the expanding private credit universe doesn’t have to be overwhelming. The principles developed and adhered to by sophisticated institutional investors can be applied by smaller institutions and individuals to select the private funds best suited for their investment portfolios.
Other Resources
As you explore opportunities in private credit, there are some good sources of information that investors can tap into for a general introduction to the sector, such as this February 2024 Note published by the Fed or Chapter 2 of the IMF’s April 2024 Global Financial Stability Report about private credit or Cambridge Associates Private Credit Strategies: An Introduction. For a deeper dive into commercial mortgage loans, this report by U.S. General Accountability Office provides a current assessment of the sector, and for the broader asset-based lending market, this paper by Apollo Global Management provides a high-level view.
Steve was formerly the Chief Investment Officer and Head of Private Markets at Manulife Investment Management. In this role, he was responsible for leading global investment teams across a wide range of asset classes, including private equity and credit, real estate, infrastructure, timber, and agriculture. Steve has served as a director of many public and private companies during his career, including two of Manulife’s U.S. SEC-registered investment advisors.
Patrick Campbell is the President and founder of Perth Advisors, a placement agent that raises private equity and debt capital for fund managers. He has been involved in over $15 billion of private placements primarily for funds and separate accounts for real estate equity and debt, LBO, venture, distressed, corporate mezzanine debt and hedge funds.
Important Notice: Private Markets Navigator does not provide investment advice, and the information should not be construed as such. Investing in private asset funds is risky, with potential for total loss and long-term liquidity restrictions. Read our full dislaimer.
