Private debt emerged as an asset class some two decades ago, but after the global financial crisis, it exploded in popularity.
Some $289 billion was raised in private credit from 2001 to 2008 at an average clip of $36.2 billion a year. From 2009 to 2019, the total amount raised jumped to $897 billion at an average $81.6 billion a year. Two factors drove this dramatic post-crisis growth in private debt. First, intensive regulation and stricter bank capital rules drove banks away from small- and midsize business lending.
At the same time, low rates on higher-quality debt produced a desperate need for yield from pension funds and other investors. As a result, private credit has matured into a mainstream complement to private equity and public debt portfolios, offering yield with low observed volatility and correlation to most risk assets. Looking ahead, the private debt market shows no signs of slowing down; Preqin expects that investor assets allocated to private credit strategies will climb 82% to $1.4 trillion by 2023, though Corbin expects the rate of growth to slow.
Such large asset flows often come with diminishing opportunities, and that is likely the case in private debt, but we think there are still attractive risk-adjusted returns in parts of the private credit market that are difficult to access and scale, such as lower-middle-market corporate lending, asset-backed lending and other niche areas like land banking. A large majority of private credit money raised is focused on lending to U.S. middle-market companies owned by private equity sponsors. Sponsor-backed lending has grown so dramatically in part because the private equity business has boomed, resulting in plenty of equity dollars looking for financing, but also because it is readily scalable. There are many large credit providers that serve this space very well, but it is crowded and highly competitive, so lenders are facing deteriorating returns.
We think that lower-middle-market lending to companies with revenues of $10 million to $50 million represents an attractive, underserved area of the private debt market. These lower-middle-market companies are often too small to attract the attention of multibillion-dollar pools of capital and are more difficult to source, but still need capital to grow their businesses or execute business transitions. This creates an opportunity for private lenders with differentiated sourcing networks and the internal capabilities necessary to analyze such transactions; investors focused on the lower-middle-market can earn yield premiums and can require structural protection unlike investors accepting looser covenants due to fierce competition in the broader private credit market.
Non-sponsored, lower-middle-market lending certainly involves risks that are different, arguably greater, compared with lending to larger sponsor-backed companies. Management quality is often less professional, and almost certainly less financially sophisticated. In the event of an additional capital requirement, without a deep-pocketed private equity sponsor already involved, liquidity needs can fast become the responsibility of the lender. If things go badly, restructuring costs tend to be larger (often much larger) as a percentage of loan balance. All of these risks need to be considered carefully, alongside loan structure and economics, when thinking about risk reward in the lower-middle-market.
We also see less competition in specialized asset-backed lending, especially short-duration situations where investors can negotiate transactions with significant structural protections. For example, we think there are attractive opportunities in land banking, which provides financing to U.S. homebuilders via short-duration structures. Specifically, these loans finance the acquisition of permitted land and horizontal development, including the construction of streets and sewers, after which the homebuilder buys back the finished lots at a pre-agreed price.
As assets continue to flow into private credit, larger lenders will continue to compete to lend to larger borrowers, leaving attractive opportunities to nimbler financiers. Investors looking to deploy capital into the private credit space will need to access less competitive areas of the market in order to earn appropriate risk premiums and protect themselves via strict covenants in the event of a market downturn.
Craig Bergstrom is chief investment officer and managing partner of Corbin Capital Partners LP, New York. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.