Over the past two decades, private credit has evolved from a niche market to a major player in the financial landscape. Between 2010 and 2023, assets under management (AUM) in private credit surged from $300 billion to over $1.5 trillion, with projections estimating growth to $3.5 trillion by 2028. Several trends have contributed to buoying the growth of the asset class.
As traditional lenders adopted a more conservative stance following the Global Financial Crisis (GFC) and recent regional bank failures, private credit providers stepped in to fill the gap. Over the past decade, numerous private credit funds have emerged to assume the roles once owned by banks, which have been restricted by post-2008 regulations penalizing riskier lending.
As banks retrenched, the increase in private credit availability benefited both LPs and GPs concurrently, further propelling the growth of the asset class. With current interest rates, LPs who sought higher returns in private equity during the ZIRP era — often to some degree to the expense of fixed income allocations — are increasingly looking to private credit as a highly attractive option for risk-adjusted returns. The income-generating nature of these investments is also likely attractive to LPs whose PE portfolios have left them cash flow negative and hungry for distributions. GPs, too, have benefited from the flexibility, execution certainty, and other attractive features of private credit, often preferring this financing over the broadly syndicated loan market.
Before the 2008 GFC’s seismic impact across the financial sector, banks were the primary lenders to corporate borrowers. To incentivize banks to hold safer assets and diffuse credit risk from taxpayers, post-crisis regulations, including Dodd-Frank and Basel III, raised capital requirements, required tightened underwriting standards, and enhanced reporting standards.
Banks became more conservative and focused on larger, more stable companies with better credit profiles, using an ‘underwrite and distribute model’ to offload credit risk from their balance sheets while earning fee revenue. The effect of this shift is perhaps best demonstrated by the dramatic increase in loan sizes across the broadly syndicated loan market. From 2020 to 2023, the high-yield bond market averaged $700 million per deal, while the leveraged loan market averaged $470 million per deal.
As a result of this trend, mid-sized companies, which often lack credit histories and seek out loans much smaller than $470 million, found it difficult to secure financing in the broadly syndicated loan market, creating a lending gap that private credit stepped in to fill. Non-bank lenders, less constrained by these post-GFC regulations, were able to offer more flexible and tailored financing solutions to mid-sized companies. This shift is particularly noticeable in the decline of loan issuances for middle market entities in the syndicated loan markets compared to pre-GFC levels.
When Silicon Valley Bank (SVB) collapsed and triggered the regional banking crisis in 2023, it similarly served as another watershed moment for private credit. Banks once again retrenched, positioning the asset class to expand its market share amid another significant liquidity crunch.
Importantly, both crises acutely highlighted several advantages of the private credit lending model compared to traditional bank financing. For one, private credit allows for better alignment between investment maturity and the term of the loans provided to borrowers, reducing the “maturity mismatch” that amplified liquidity problems for banks in the GFC and then again in the regional banking crisis.
For instance, SVB’s issues with mismatched long-term assets and short-term liabilities during the Fed’s rapid interest rate hikes illustrate lending challenges traditional banks face. The swift devaluation of the bank’s long-dated bonds resulted in significant unrealized loan losses and a subsequent run on deposits.
Private credit doesn’t suffer from this vulnerability. Unlike banks, which rely heavily on customer deposits (often uninsured) for lending, private credit funds loans with committed capital from institutions whose long-term investment horizons align with the loan holding period. Additionally, private credit loans are less sensitive to rising interest rates and typically have capital reserves on their balance sheets, enhancing their resilience during periods of volatility or economic downturns.
As private credit firms have become a prominent lending source over the past two decades, sponsors have developed a growing preference for the unique advantages private credit solutions can offer. Unlike the leveraged loan and high-yield bond markets, private loans are not intermediated by a bank or reliant on a large syndicate of investors (often 30-100). As a result, these transactions reduce execution risk, offer more flexible structures, and close faster.
For example, with fewer participants on a loan, private credit lenders often develop a closer relationship with borrowers, gaining deeper insights into a company’s underlying conditions. This enables private credit lenders to offer more customized structures, including flexible repayment terms, covenants, and pricing.
This relationship-focused approach proved especially advantageous during Covid-19. Private credit exhibited notable resilience compared to the broadly syndicated loan market, which traded down materially. This resilience is attributed to the tailored nature of private credit deals and the ability of lenders to engage directly with sponsors and management teams.
Execution certainty and speed also enhance private credit’s appeal. Syndicated deals involve a larger group of lenders and can remain in the market for up to a month, creating notable market and execution risk. Further, syndicated deals often flex prices wider or tighter depending on market conditions. In contrast, direct lending private credit deals typically have fixed pricing from the outset, providing sponsors with greater certainty regarding terms. The direct negotiation and underwriting process and ability to bypass rating agencies also serve to streamline the process.
Deal structuring can be much easier, too. For example, obtaining a first and second lien credit agreement in the syndicated market requires negotiating two different agreements. In contrast, unitranche financing available via private credit combines what would traditionally have been separate first-lien and second-lien loans into a single loan agreement. This unified structure removes the need for multiple, separately negotiated credit agreements that may contain conflicting terms. Further, with a single credit agreement, the risk of disputes between different classes of lenders is significantly minimized.
These are just a few of the features that make private credit appealing to sponsors. Additional advantages for sponsors include fewer disclosure requirements (for now), the option to seek incremental or follow-on funding, and more.
The growth of private debt AUM is also being fueled by institutional investors’ rising appetite for the asset class. A June 2023 Preqin survey revealed that 45% of LPs intend to commit more capital to private debt within the next year, while 51% plan to increase their allocation in the long term. Several factors have contributed to allocators’ growing interest in private credit.
For one, the sector is gaining appeal due to the high interest rate environment, which positions private credit loans to outperform leveraged loans and high-yield bonds. Benefiting from their floating rate nature and illiquidity premium, direct lending loans are currently underwriting yields exceeding 11%. Further, with base rates soaring, private credit firms can stay senior in the capital structure while accessing these returns.
In contrast, leveraged loans, which also feature a floating rate, currently offer yields below 10% on average. Additionally, despite high interest rates buoying current returns, private credit loans have historically outperformed the broadly syndicated loan market with lower volatility.
Private credit’s advantages are even more pronounced compared to the high-yield bond market. High-yield bonds, being fixed-rate, are highly sensitive to interest rate fluctuations, exposing them to duration risk. This has become especially evident recently, as rising rates have significantly impacted their valuations.
Moreover, private credit’s downside protection extends beyond shielding against interest rate sensitivity. Direct lending, for instance, has historically exhibited better credit loss ratios than the high-yield bond and leveraged loan markets. Extensive due diligence, covenants, ongoing monitoring, and close borrower relationships have enabled these loans to show notable resilience during market downturns in 2008, 2015, and 2022.
These factors, along with benefits like diversification and low market correlation, contribute to private credit’s attractive risk-adjusted returns. This said, private credit allocations come with their fair dose of complexity and nuance that LPs must take into account. Performance dispersion is considerable, underscoring the importance of manager selection, and differences in credit quality across regions, sectors, and issuers are another important factor. Further, while high interest rates can boost yields, they can equally strain borrowers’ cash flows, surfacing default risks. For example, U.S. private credit default rates saw an uptick in Q2, rising to 2.7%, compared to 1.8% in Q1.
As these trends have fueled private credit growth, the asset class has become increasingly specialized and sophisticated. While direct lending to middle-market companies traditionally dominated the sector, private credit has evolved to service larger transactions, include a range of strategies — from opportunistic and distressed credit to asset-backed lending and fund finance — and cover all layers of the capital stack. With trillions in private equity dry powder waiting to be deployed, the market for private credit is poised for continued expansion. However, some critics suggest that the golden era of private credit may end, citing the ongoing recovery of the US syndicated loan market as banks seek to regain market share from private credit firms and consolidation in the space exhibited this year.
Get updates in your inbox
Learn how Chronograph can streamline your private capital investment monitoring and diligence