The Rise of Private Credit: A Growing Alternative to Traditional Lending

Private credit is defined as a privately negotiated bespoke lending strategy whereby non-bank lenders lend money directly to small and medium-sized businesses. Private credit has grown as a viable alternative to bank lending, offering tailored and flexible funding options and ensuring speed of transaction execution and closing.

Although private credit emerged about three decades ago, it grew in prominence in the aftermath of the global financial crisis as stricter regulatory norms and volatile market conditions forced banks to tighten lending standards. Borrowers, consequently, turned to non-traditional sources of funding such as hedge funds, private credit firms, and alternative asset managers to raise capital.

According to an IMF study, the global private credit market was valued at more than $2.1 trillion in 2023 in assets and planned capital deployments. Private credit addresses borrowers’ specific funding requirements and therefore transactions in this space can sometimes take months to negotiate and originate. Private credit is not issued or traded in an open market.

Asset Classes within Private Credit

While the private credit ecosystem is complex and dynamic, it has nonetheless garnered significant share of the lending market in recent times. Private credit offers various asset solutions that come with varying degrees of risks and returns. Some of these asset classes are discussed here:

Senior Secured Loans: As the name indicates, these loans, often for relatively shorter terms of between three and eight years, are secured by the borrower’s assets, also called collateral. In case of a loan going into default, the lenders – or the securities holders – have the first right to the underlying assets over all other credit obligations of the borrower.

Mezzanine Loans: Mezzanine loans are a hybrid form of financing, sitting between debt and equity financing and according the lender the right to structure or convert the loan to equity if the borrower defaults on the loan payment. Mezzanine loans rank below senior secured loans in priority and are usually availed to fund buyouts and expansions.

Infrastructure Loans: Once considered banks’ traditional turf, the infrastructure ecosystem has seen increased lending activities from private credit players who have been keen to fund infrastructure projects, for instance, in traditional but critical domains such as highways and ports, and in emerging fields such as clean energy and data. Since these are essential services, the chances of a default are significantly diminished and lenders are often assured of attractive returns.

Special Situation Loans: A special situation is an unforeseen event that has the potential to impact the operations of a business. Special situation loans help businesses finance or reorganize their complex debt, address underperformance issues or balance sheet distress, or other similar events influencing their financing needs. Because of the nature of these issues, analyzing these companies maybe sometimes inherently difficult.

Venture Debt: It is a type of debt financing that mainly caters to venture-backed companies in the innovation economy. Most early-stage companies and startups have already raised funding from equity capital investors in exchange for a stake and may not be in a position to dilute additional equity. These firms then tap the credit markets to raise funds. For investors, an investment in these firms offers great growth potential and hence greater return on their capital.

Investment strategies and including private credit in portfolios

In the current macroeconomic environment of persisting inflation, private credit has emerged as an important source of diversification away from riskier assets and as an avenue of enhancing income. Private credit covers a slew of investment strategies, which can be broadly categorized under two heads: capital preservation and return maximization. Capital preservation is generally conservative and aims to prevent or minimise losses in a portfolio. Return maximization, on the other hand, simply implies maximizing returns by analyzing the investment horizon, financial goals, and risk-taking ability of investors.

As is typical with almost any investment instrument, strategies with risk reduction at their core yield lower returns, whereas those with higher risks typically yield more. One of the driving forces behind these strategies, therefore, is the yield differential over, for instance, traditional fixed income instruments, as investors seek to preserve capital and boost returns. These strategies can take different forms based on the type of debt one is investing in, but they nevertheless allow investors to align fund allocations based on their risk profile, investment objective, or the targeted period of investment.      

Benefits of Private Credit

For small and medium-sized businesses, which are highly leveraged and often operate in the middle market space, accessing traditional sources of financing such as a bank loan could prove difficult. For investors, private credit not only offers an avenue for diversification in times of volatility, but can also offer lucrative risk-adjusted returns in the double digit range.

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