This piece was jointly written by Chronograph and Sirvatus.
Is the golden era of private credit over? Private credit has seen remarkable growth since the Global Financial Crisis, filling the lending gap created by bank retrenchment, becoming a preferred source of financing for sponsors, and attracting significant capital from institutional investors. However, rising interest rates, concerns about borrower health, mounting default concerns, and the narrowing spread between public and private credit fuel debates about the sustainability of private credit’s growth moving forward. Here, we explore dynamics across the public and private credit markets and the role of interest rates in shaping the asset class.
Several trends have pressured the attractive spreads that private credit has secured in recent years. For one, the broadly syndicated loan (BSL) market has steadily recovered throughout 2024. Bank’s risk appetite has reemerged, borrowing spreads on newly issued credits have dropped to multi-year lows, and price flex activity has skewed to favor borrowers.
As a result, some buyout firms have turned to the BSL market to refinance private credit loans, typically achieving savings of 300 basis points on second-lien or unitranche loans and reducing interest costs by millions of dollars. Over $13 billion direct lending loans have been refinanced with a BSL transaction so far this year. Notable examples include Paraxel’s and Mavis Tire’s $3.2 billion and $2.5 billion refinancings, respectively.
Additionally, private credit spreads have also been pressured by a dearth of M&A and LBO activity. As both markets compete for limited deal flow, increased competition has evaporated the pricing premium private credit loans commanded in recent years. For example, in 2023, private equity borrowers roughly paid a 200 basis point premium in the private credit market to finance buyouts and M&A deals. So far, throughout 2024, spreads have stayed tighter, with BSL deals often in the 400-500 bps range compared to 475-625 for direct lending transactions.
Together, these trends have coalesced to increase pressure on private credit lenders, many of whom have sought to fight back against increasing competition with reduced spreads, waived fees, and marketing the creative deal structuring features for which the asset class is known.
Will revived leveraged loan and high-yield bond markets begin to erode the market share that private credit built up? As the syndicated market recovers, questions have surfaced about whether private credit can sustain its impressive momentum moving forward. However, while bank retrenchment has certainly acted as a catalyst for the space, it does not overshadow the robust secular trends likely to continue buoying the asset class.
For one, private credit will continue to ride the coattails of private equity’s growth more broadly. With over $3 trillion in private equity dry powder sitting on the sidelines and an uptick in M&A activity expected over the next year, private credit lenders will provide a crucial outlet for sponsors financing an influx of backlogged deals. Additionally, a functioning BSL market doesn’t diminish the appeal of private credit financing, which offers advantages like faster transaction times, certainty, bypassing the rating process, no price flexing, and collaboration with a smaller group of investors.
Further, despite the functionality of public credit markets, regulatory constraints will continue to create gaps that private credit steps in to fill — evidenced by its growing role and pursuits in investment-grade and asset-backed financing.
This said, increased competition will likely leave its mark on deal composition. Different markets require different playbooks, and private credit lenders must remain agile to shifting dynamics and innovate their products and strategies accordingly. For example, over the past 18 months, large unitranches and non-fungible add-ons found a home with private credit shops, as the syndicated markets weren’t supporting these transactions.
With the BSL market reopening, unitranches are expected to occur at smaller transaction volumes than in the past two years, and private credit deal composition will likely start to occupy junior levels in the capital structure. Adapting and finding corners where private debt financing can provide a differentiated solution will be crucial. Amid current dynamics, features like delayed draw financing for buy-and-build strategies and creative paid-in-kind (PIK) structures will continue to attract borrower interest.
Additionally, enhanced competition will favor private credit firms with scale and flexible capital and pressure those with niche focuses. As sponsors assess both public and private credit financing sources, one-stop-shop providers that operate and can price risk across both markets will likely be less affected by competitive dynamics compared to smaller, more specialized private credit players that have popped up in recent years.
Additionally, while headlines tend to orient towards the competitive dynamics between the public and private credit markets, more nuance exists below the surface. Competition is certainly present, particularly on a deal-by-deal basis. Private credit firms vie with banks for direct lending deals, and the spreads and premiums they can charge are directly correlated to how opened or closed the broadly syndicated market is. However, often left out of the narrative is the increasingly collaborative part of the ecosystem.
For one, more and more banks and private credit shops are partnering to share the risk and returns of direct lending deals through joint ventures. Generally, banks originate the assets, but the companies ultimately go onto a balance sheet structure where most of the capital is provided by a private credit firm. Wells Fargo’s partnership with Centerbridge and Citigroup’s with LuminArx Capital offer prime examples of this trend.
Further, banks and private lenders also increasingly rely on each other to meet different funding needs. For example, many private credit shops leverage their funds to boost returns. The BIS estimated that in 2020, roughly half of private credit managers borrowed against fund assets, and this leverage is almost entirely funded by bank-issued debt.
Banks equally depend on private credit firms for funding balance sheet solutions. When banks face rapidly growing loan portfolios and need to mitigate risk and seek regulatory relief, private credit firms often step in, typically through synthetic risk transfers (SRTs). In these transactions, private credit shops sell insurance on a portion of a riskier tranche in a pool of loans on a bank’s balance sheet. In exchange, banks pay private credit firms an annual premium.
Private credit firms provide the cash collateral for this “insurance” upfront — an important distinction from the credit default swaps used in the GFC — often borrowing the cash they need for this collateral to boost the return on the bank’s premium payments. The interconnectedness and the complex layers of leverage between the two markets have been central to the increased concerns about potential systemic risks. This dynamic perhaps warrants scrutiny as retail exposure to private credit increases through perpetual fund vehicles.
Alongside heightened competition with the BSL market, interest rates have also been shaping trends in the asset class. Higher interest rates ultimately act as a double-edged sword for private credit: they boost returns while squeezing borrowers. For example, the asset class has certainly been a benefactor of the high interest rate environment. With base rates at their highest levels in decades, the returns on first-lien loans have recently approached 12-13% — that’s a significant boost against historical return norms.
Equally noteworthy are the pressures this environment places on borrower health. The floating rate nature of these loans means many portfolio companies that borrowed when rates were near zero now face a much harsher economic reality. With higher interest payments, cash flows are increasingly strained, reflected in interest rate coverage ratios at their lowest levels in recent years. Compound higher interest rates with a slew of other macro stresses over the past several years, like inflation, weakening consumer demand, and looming recession concerns, and it quickly illuminates the risks facing private credit.
And nearly three years into this high-rate environment, certain balance sheets are feeling the pinch as companies struggle with muted earnings, tighter margins, and face base rates that are 350-500 basis points higher than when they were originally financed. Although widespread credit stress has not materialized, signs of strain are starting to percolate below the surface. Private credit default rates have risen for the third consecutive quarter, hitting 2.71% in Q2. However, notably, these default rates are lower than those exhibited in the BSL market, currently hovering at roughly 4%.
While some market participants posit that default rates are artificially low among direct lending borrowers, this phenomenon is largely a function of elevated amendment activity. As credit stress has started to bubble, direct lenders have worked closely with borrowers and sponsors to proactively address looming defaults, leveraging tight relationships to restructure deals in exchange for enhanced economics.
Most of the amendment activity has been pricing-related. Lenders are opting to shift some of the cash burden to PIK providing near-term cash relief to the borrower, usually at a higher all-in rate. Many transactions originated in the last several quarters have included PIK features from the outset, offering borrowers flexibility to delay cash interest payments by capitalizing them into the loan’s principal.
A study on business development companies (BDCs) by S&P Global found that PIK interest was increasing as a percentage of gross investment income for private lenders, and in May, Fitch Ratings reported that pressures at portfolio companies drove PIK interest to an average of 9% across its 24 BDCs, a notable increase from 6.8% in 2020 and 3.6% in 2019.
The uptick is significant, as excess PIK impacts a private credit fund’s cash flow, potentially straining its ability to meet dividends while also affecting borrower leverage and risk. However, sponsors and lenders have a knack for finding creative solutions in challenging market conditions. The recent emergence of synthetic PIKs in private credit exemplifies such innovation.
Synthetic PIK arrangements enable lenders to offer a company two pieces of debt: the primary loan the company originally intended to borrow and a smaller delayed-draw term loan. When companies dealing with liquidity issues need to pay interest on their primary loan, they can use the delayed-draw term loan to make these payments in cash. These structures help lenders mitigate fund cash flow and dividend concerns. However, like traditional PIKs, they ultimately add more debt to a borrower’s balance sheet.
Additionally, in combination with pricing amendments, maturity extensions and sponsor equity infusions have also been leveraged to ease liquidity concerns and place borrowers on stronger footing in response to an evolving macro environment.
The anticipated easing of monetary policy in the coming months has surfaced questions about what private credit returns will look like going forward. On the one hand, rate cuts will likely alleviate some stress for borrowers. Simultaneously, the high yields that private credit has enjoyed recently are likely to decline.
This said, deconstructing historical private credit performance unveils a very durable, consistently attractive return. Many private credit shops can easily point to a track record of generating strong returns in both high and low-interest-rate environments, as well as in volatile and stable markets.
Like other refrains that have permeated private market asset classes over the past several years, more pressure on the “beta components” of returns will result in a clearer bifurcation between the best and worst managers. Alpha-creating capabilities around loan and structuring will be increasingly important, acutely highlighting the significance of manager selection.
Of interest is how institutions will and are responding to interest rates in their private credit allocations. This year, for example, pensions have shown mixed reactions — some are reducing allocations due to concerns over borrower health amid higher rates, while others pour money into the asset class and remain bullish on returns.
As potential rate cuts loom, it will be interesting to see how this influences private credit allocations and the assessment of the asset class among LPs. Chris Ailman, the recently retired CIO of CalSTRS, has suggested that rate cuts could dampen allocator’s interest in the asset class. Further, as the spread between public and private credit returns narrows, it begs the question of whether the difference justifies the lack of transparency and liquidity. That said, a 100-200 bps difference can still be significantly material for many institutions.
Chronograph was founded by GP and LP investors to bring modern technology to private capital markets. Built for all fund types, Chronograph GP automates portfolio company data collection, analytics, valuation, reporting, and information warehousing, allowing investors to redeploy time to strategic priorities. Learn how Chronograph empowers private capital firms with flexible data collection tools, unmatched data accessibility, and seamless data integrations across point solutions.
Sirvatus is a comprehensive loan operations platform engineered for direct lenders to seamlessly manage the operational burden inherent in today’s financing structures. Built by deal professionals who have structured and restructured transactions, Sirvatus modernizes loan administration and loan agency through a single system of truth that balances flexibility and structure to provide an exceptionally modern experience across the front, middle, and back office. Learn how Sirvatus equips loan operations professionals with modern software to manage complex deal structures and activity, automate and simplify borrower and co-lender collaboration, and streamline manual and time-sensitive operational and data management processes.
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