It sounds mysterious, but it’s really just a loan—often a risky one—made by an investment fund instead of through a bank.
Hedge funds? Quant trading? Old news. These days, everyone within shouting distance of Wall Street is talking about private credit—even if some of those people might admit that they still aren’t 100% sure what private credit is.
The industry is minting billionaires. It’s become a huge chunk of the assets of private equity giants such as Blackstone, Apollo Global Management and KKR, so much so they now want to be called “alternative asset managers.” The new crop of prestige companies in Manhattan—the places that ambitious young bankers are jumping ship for—are private credit specialists. The draw is the promise of high returns, chunky management fees and the thrill of a market that’s grown by more than $1 trillion in assets under management in only a decade. But that name, private credit. It could mean almost anything. Haven’t people been privately lending money to each other forever? Isn’t that just what a bank does?
Banks used to be where the action was in lending. But in recent decades—and especially since the financial crisis of 2008—more and more of the money for loans comes from investment funds instead of banks. In a nutshell, private credit is a catchall term for the most opaque part of this market. Here’s what you need to know to see it more clearly.
What’s so “private” about it?
In equities, the distinction between public and private investment is sharp. If it’s a company with a stock ticker that anyone can buy a share of, like Apple Inc., it’s public. Everything else is private. In the world of debt, it’s more complicated. There are widely traded bonds such as Apple’s highly rated debt. But there’s also a huge market of more specialized assets including syndicated leveraged loans. Similar to bonds, these are arranged by banks, which collect a fee but then aim to sell the asset to investors that may include insurers, pensions and mutual funds.
In private credit, the manager of a large investment fund can skip the step of working with a bank and make a loan to a company directly using investors’ money. And unlike with a bank, private credit funds typically hang on to the loan until maturity, collecting payments and passing them on to investors. So private credit doesn’t trade often. On Wall Street, it’s said that banks arranging loans are in the moving business, whereas private credit funds are in the storage business.
One new wrinkle: As the private credit market has gotten hotter, banks themselves have been trying to break into it. They’re striking partnerships with private credit funds in an effort to win back some of the fee income they’ve been losing to their new rivals.
What kinds of loans are these funds making?
Private credit can fund almost anything. But the heart of the business has long been loans to midsize companies that have been acquired in a leveraged buyout. In an LBO, a private equity fund buys a company using lots of debt, which ends up on that company’s books. By acquiring businesses with borrowed money, PE funds and their investors can magnify their returns. The potential downside is that the company can end up with a lot of bills to pay, raising the risk of default or bankruptcy. So these loans can be risky.
Over time, private equity managers realized there was money to be made providing the loans used in LBOs, too. That’s one reason many of the biggest names in private credit are companies mostly known for PE. Within the growing credit operations of these money managers, they are often financing their competitors’ buyout deals. Many of these firms also work with insurance companies or own one outright. Insurers control huge piles of cash that they can invest in loans.
The private credit label is now applied to a growing menagerie of assets. It can include corporate loans to blue-chip companies, real estate lending, financing for “buy now, pay later” loans and infrastructure debt. It even reaches into niche areas such as agriculture and litigation finance, which pay for lawyers up front in exchange for a piece of lawsuit winnings.
What’s the appeal?
The funds that make private loans have one superpower: Most of their money comes from institutions or wealthy individuals who commit to locking up their cash for years, or in funds with limits on withdrawals. This kind of sticky money allows them to ride through bumpy markets and make loans on terms bankers and bond investors wouldn’t stomach. For borrowers with weak credit—say, a small company that already has a lot of debt or a fast-growing tech company that hasn’t turned a profit yet—a private loan might be the only option. Funds can also offer borrowers more flexible terms, such as the ability to defer interest payments.
The reward for this is that borrowers pay more, so the funds get a higher return. The Cliffwater Direct Lending Index tracks over 16,000 directly originated loans and has returned more than 8% annually over the past decade. By comparison, the US leveraged loan market, where broadly syndicated corporate loans are traded, has posted annual returns of around 4% in the same period.
Taking a page from private equity, the managers of private credit funds may also collect a management fee of 1% to 2% of assets per year, plus around 15% of profits above a certain level. That’s a much sweeter deal than running a public markets bond fund, where fees run about 0.37% per year, according to the Investment Company Institute.
Is there a catch?
A study published by the National Bureau of Economic Research last year argued that private credit hardly offers any advantage to investors above public markets assets, once you account for funds’ higher fees and the additional risks of private loans.
Because private credit doesn’t trade on secondary markets, it’s not easy to know its exact value at any given time. Skeptics of private market investing say this fact gives fund managers leeway to grade their own homework. They report the fair value of the assets in a fund each quarter, though most hire third-party companies to provide an opinion. For investors in the funds, this cuts two ways. The values don’t change as often as they might in a public market, so the investment appears to be less volatile. But this also could end up masking problems with a loan—leading to big losses when they finally burst into view.
Different lenders to the same company have on some occasions come up with wildly different assessments as to the loan’s worth. In some cases lenders have been reluctant to mark down the value of loans that had become distressed, Bloomberg has reported.
So should I worry about all the money going into private credit?
Private credit managers generally are subject to only a fraction of the regulation and oversight that banks have faced since the 2008 financial crisis. The industry says there’s a good reason for this: Unlike banks, these investment funds aren’t taking risks with the money of depositors or short-term investors, so there’s less danger of a panic in downturn. In this view, putting risky debt into funds instead of banks is good for financial stability.
Yet there are a lot of unknowns in this market—it’s private, after all. Some credit funds are required to make quarterly Securities and Exchange Commission filings that include a full list of their investments. Fund managers often argue that these disclosures make them a lot more transparent than banks. But multiple regulators closely scrutinize banks’ underwriting and lending practices.
Credit rating company Moody’s Ratings has pointed to the increase in bank lending to private credit funds. That’s gotten the attention of watchdogs: Bloomberg has reported that the European Central Bank has asked major banks for details on their exposure to private credit firms. The Financial Conduct Authority in the UK and the SEC have raised concerns about whether private credit assets are being valued correctly.
So far, private credit has boomed in the best of all possible worlds for it. First, a decades-long decline in interest rates boosted demand for any investment that could pay better than the rock-bottom yields mainstream bonds were paying. When rates finally shot up after the pandemic, private credit was protected, because its loans typically have floating rates. The worst-case scenario—that higher rates push the economy into a recession, causing more businesses to default on private loans—didn’t materialize. There have been some signs of strain, such as an uptick in debtors taking advantage of the option to defer payments. This fast-growing market has opened the door to riskier borrowers, and we’ve yet to see how it will fare through a prolonged downturn. Or how it might affect the rest of the economy if things go wrong.
Written by: Kat Hidalgo and Paula Seligson @Bloomberg
The post “Private Credit Is the Hot New Thing on Wall Street. But What Is It?” first appeared on Bloomberg