The biggest threat to the private credit industry comes from itself. Direct lenders like Ares Capital and Apollo Global Management have become big players in funding buyouts thanks to their ability to offer flexible debt packages and generous terms. Now that credit markets have turned, Breakingviews explores whether the $1.2 trillion industry can keep grabbing market share from banks and public markets.

Why is private credit so hot?

Before 2008, banks generally dominated the world of corporate credit, underwriting debt and either holding it on their balance sheets or selling it to others. New rules introduced after the financial crisis discouraged regulated banks from serving small and risky borrowers. Private lenders, which raise funds directly from institutional investors and aren’t covered by the same regulations, stepped in. In 2004, 60% of the loans that banks arranged and placed in public debt markets were worth less than $250 million, according to S&P Global. By 2020, that proportion had fallen below 10%.

These private – or “direct” – lenders have since moved on to much larger loans. In 2010, the average company borrowing from Ares, one of the largest private credit firms, had annual EBITDA of $37 million. By 2021, the typical borrower’s EBITDA was $162 million. In the process, private credit has mushroomed into an asset class managing $1.2 trillion, according to Preqin.

Direct lenders are now replacing banks and public debt markets in financing some of the very biggest takeovers. Buyout firm Thoma Bravo recently tapped private credit funds including Golub Capital and Owl Rock Capital to help finance its $10 billion takeover of software developer Anaplan. Security software group Kaseya used private credit to help pay for its $6.2 billion takeover of rival Datto. Direct lenders have also arranged large corporate credit facilities: Japan’s SoftBank borrowed $5.1 billion from Apollo.

Buyout firms, which rely heavily on debt financing, are natural customers for direct lenders. Transactions involving a financial sponsor accounted for 80% of direct lending deal activity in 2019, according to Dealogic. Indeed, the two businesses are increasingly intertwined: Groups like Blackstone and KKR now have their own direct lending operations.

How do private lenders beat banks?

When a company negotiates an acquisition, it can fund the deal in public markets or go private. In the former case, the buyer asks one or more banks to underwrite the debt; these lenders then typically sell it on to investors. So-called syndicated bank loans currently charge a borrower with a single-B credit rating over six percentage points more than interbank rates. That’s up from a spread of around three percentage points at the beginning of the year, when markets were calmer. Back then, private credit funds typically charged a bit over a percentage point or so more.

But the terms offered by banks aren’t set in stone. Lenders reserve the right to raise the interest rate on the loan, if necessary, to entice buyers. This provision is known as flex. When markets are choppy, those conditions erode banks’ price advantage. Direct lenders’ rates, though still above banks’ initial interest rates, had often moved below the flex rates.

Now, they are moving even further. With syndicated debt markets almost entirely shut down for the biggest, riskiest loan packages, private credit funds are sometimes beating banks on price.

These funds already had a bigger appetite for risky loans. Regulators in the United States and Europe advise banks to limit leverage to 6 times a company’s EBITDA. Direct lenders are typically willing to finance higher multiples. Recently, they’ve gone further, lending to unprofitable companies by basing loans on the borrower’s annual recurring revenue, rather than its cash flow. That was the case with Anaplan.

Direct lenders can also provide borrowers more flexibility. Private equity firms will often buy a company with a view to adding on further purchases. Direct lenders can offer undrawn facilities – often worth as much as a third of the total loan package – to fund these future transactions. That’s something public debt facilities cannot match.

Privacy is another source of competitive advantage for private credit funds. A buyout firm can line up financing for a takeover without worrying that the news will leak out through its banks. Once a deal has closed, financial information is limited to a tighter circle of creditors. Given those advantages, it’s little wonder that direct lenders have built close relationships with private equity groups.

What’s the appeal for investors in credit funds?

Higher returns. Because investors are locked into a credit fund for its life of, say, eight years, they expect to receive a higher return than they could get on widely syndicated debt, which is more easily bought and sold.

That higher return can be deceptive, though. When private lenders offer more generous terms than public debt markets or lend to riskier companies, they should charge more. A private loan yielding 6% over interbank rates may look attractive next to a public loan with a 5% spread. But if the direct loan represents a higher multiple of the borrower’s EBITDA, the risk-adjusted return may be similar. As lenders trip over each other to put capital to work, investors may be getting little compensation for tying up their money.

Some direct lenders promise investors an annual return of 10% or higher, even though they charge less than that on their loans. One way to do that is to set aside part of the fund for riskier subordinated debt, which pays a higher interest rate. Some private credit funds also take on debt of their own, boosting potential returns for investors. This is far short of the leverage used by banks, but still amplifies risks.

What are the dangers?

The good news is that direct lenders aren’t like banks. Investors in private credit funds cannot typically pull out their money at will, meaning the vehicles are less vulnerable to a sudden loss of confidence that could spiral into a systemic crisis. Some funds are publicly listed, giving managers access to permanent capital. That said, some private credit funds are moving towards allowing investors to make periodic withdrawals. Though these are limited to around, say, 5% of the fund’s assets every few months, it increases the danger that the fund will have to liquidate assets in a hurry.

Valuations are also murkier. As direct loans are not publicly traded, it might be easier for managers to hide poorly performing credits. Private credit firms could face pressure not to declare a private equity loan in default for fear of alienating their best clients. That’s particularly worrisome since the big financial sponsors account for so much of many lenders’ business. Managers might also seek to lower their reported default rate by letting troubled companies extend loans.

What happens now?  

The biggest threat facing direct lenders, though, is the flood of money that has flowed into the sector from investors seeking more attractive returns. Private credit funds have $390 billion of unspent capital to deploy, Preqin reckons. More of their loans now come without covenants that test leverage regularly, making it harder for creditors to control struggling companies. The emergence of recurring revenue-based loans is potentially another sign of excessive risk appetite.

This exuberance will be tested now that central banks are aggressively raising interest rates. Higher borrowing costs and choppy markets have chilled banks’ willingness to make leveraged loans. Private credit funds, however, are still putting money to work: a group of direct lenders led by Blackstone last month put up $4.1 billion to fund the $10 billion leveraged buyout of software maker Zendesk.

Yet with the credit cycle starting to turn, private credit funds face their first big test since the industry started its post-2008 growth spurt. How they navigate the cycle for their investors will determine whether direct lenders’ market share gains are durable, or whether banks can win back the territory they have ceded.

More By This Author: