Commentary: Why private credit's 'golden moment' isn't over yet

In 2023, Blackstone President Jon Gray declared a “golden moment” for private credit, and recently, the world’s largest alternative asset manager said that this $1.7 trillion market class is set to swell to $25 trillion.

With increasing volatility in traditional capital markets over the past few weeks, highlighted by plummeting stock prices, private credit has become a flexible and reliable alternative. When traditional capital dries up, it provides businesses with the necessary funds to navigate challenging economic conditions and pursue growth opportunities.

However, this shift toward private credit is by no means new. Following the global financial crisis, tighter lending and banking regulations opened the door to private credit. Buoyed by higher base rates and a marked shift away from traditional bank lending, the $1.7 trillion asset class has emerged as an increasingly attractive source of funding for private equity on both sides of the Atlantic.

Debtwire data shows that European direct lending now funds three-quarters of leveraged buyouts — a sharp rise from just 25% in 2020.

Despite this, some industry commentators question the endurance of private credit, pointing to a slowdown in the pace of buyouts and a liquidity crunch faced by private credit funds.

Yet it is clear that there is a space for private credit as a viable financing alternative to both banks and private equity long term, particularly for the underserved middle- and lower-middle market.

Private credit’s meteoric rise

Debtwire tracked the rise of this asset class in the years since the financial crash when banks began retrenching, prompting deepening demand for private capital solutions.

According to our data, direct lending in particular has fast become the private credit strategy of choice for institutional investors, providing a critical alternative funding source from traditional lending channels, with U.S. deal volume reaching heights of $62 billion in the fourth quarter of 2023.

In addition to the retrenchment of the banks, private equity has also been hit by macroeconomic headwinds, as a gap in valuations and over-allocation has slowed down financing for deals. This created an opportunity for private credit to take market share and lend directly to private equity portfolio companies to fund leveraged buyouts. As a result, Debtwire data shows that direct lending now accounts for just over a quarter of European buyout financing in 2023 and 2024, with public debt markets providing 25%–45% of capital.

Branching out into private credit has also become a way for investors, or limited partners, to diversify their holdings, providing a much-needed buffer against macroeconomic and inflationary headwinds while protecting against price fluctuations in public markets.

In addition to private credit, other alternative asset classes have also stepped into the limelight as private equity and bank lending have stuttered. Infrastructure and private real estate provide a greater opportunity for capital appreciation, depending on the quality of the asset and risk profile, while infrastructure can provide a reliable return, regardless of economic downturns, due to the nature of the asset class. However, it is direct lending that has emerged as king among alternative asset classes, thanks in large part to the promise of higher yields and greater flexibility.

The dramatic rise of direct lending — from supporting just a quarter of new European LBOs in 2020 to dominating the market in recent months — indicates a significant increase in the market share for private credit. At the same time, a near-total absence of high-yield bonds in new LBO financings in the first quarter of this year, coupled with the limited use of leveraged loans, underscore a clear trend away from more traditional public market financing.

Not without risks

Private credit is not without its risks, however, and there are signs that the market is beginning to slow. Debtwire data demonstrated a drop in overall European buyout volumes to less than €100 billion ($110 billion) in 2023 from €250 billion in 2021. Furthermore, concerns are mounting that the private credit market may experience a liquidity crunch due to reduced financing activity, potentially leading to reduced returns, both in absolute and relative terms.

Private credit providers are now shouldering the burden of defaults, too. A report published by Debtwire showed that since 2018, direct lenders have fully or partially equitized at least 61 loans to companies backed by some of the biggest names in private equity, including KKR, Carlyle, CVC and Bain Capital.

As the cost of servicing floating-rate debt has increased, many private equity portfolios have struggled to meet interest payments. In many instances, this forced lenders to step in to take over control of troubled companies hamstrung by untenable debt levels under messy restructurings. In the latest example of a leveraged-buyout-gone-wrong, Vista Equity is reportedly in talks to cede control of educational software provider Pluralsight — which it acquired for nearly $4 billion just three years ago — to its lenders. Pluralsight’s lenders are a who’s who of private credit, including Blue Owl Capital, Ares Management, Goldman Sachs, Golub Capital and Oaktree. This should serve as a reminder that just because a deal is big doesn’t mean it is absent of risk.

There are also questions about the long-term viability of private credit. Due diligence for private credit is notably more complex compared to public markets, requiring additional expertise within asset management firms. As more lending shifts toward private credit, the less transparent the market becomes, hence the possibility of systemic risk. Lack of transparency in a relatively immature market is also a concern, as assets are more likely to be overvalued, leading to concerns around a dangerous bubble. In turn, regulators globally have sounded alarm bells, calling for increased transparency around valuations across the board.

An enduring feature

Despite this, returns on private credit have remained strong over the last two years, and while overall buyout volumes may have dropped, our data shows that the share of capital market debt financing has increased. So far in 2024, European debt capital markets have amounted to over €200 billion in leveraged loans and €85 billion from high-yield bonds — easily their highest totals since the record-setting levels attained in 2021. Meanwhile, direct lenders reached a new quarterly high in the second quarter of this year having provided €34 billion in financing.

Additionally, there is demonstrable trend of a "flight to scale" when it comes to fundraising. This month saw HPS Investment Partners raise one of the largest private credit funds on record, accumulating $21.1 billion for its Specialty Loan Fund — one of the largest sums ever raised by a traditional direct lending fund.

Direct lenders continue to be the preferred financiers for small- and mid-sized companies. Private credit funds can cater to borrowers considered higher risk or ineligible for traditional bank loans — often the case for many fast-growing companies, which may be slow to turn an initial profit. Additionally, private credit deals offer the advantage of upfront pricing in comparison to leveraged loans, which are more vulnerable to market fluctuations.

As a result, deal counts are on the rebound in both the small-cap and middle-market segments of the direct lending market. Debtwire recorded 79 new small-cap deals in the first quarter of this year, alongside a further 92 mid-cap deals.

Ultimately, private credit is deserving of its place as a permanent complement to bank lending, and a critical component of the lending market long term, particularly in times of increased volatility. Its flexibility and focus on the underserved middle- and lower-middle-market provide borrowers with tailored solutions beyond the constraints of traditional bank models, and remains a readily available source of financing, to rival bank lending and private equity.

Yana Morris is chief content officer at ION Analytics where she leads a team of 500 domain experts focused on capital markets. Through its core brands — Debtwire, Dealogic, Mergermarket, and Infralogic — ION Analytics informs the decisions of banks, law firms, and advisers worldwide. 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.