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The rise of private credit: who, what, where and why

29 Jul 2020

Marking a decade of significant growth, total global private credit assets under management (AUM) had grown to US$767.5 billion by the end of 2018, up from US$237.9 billion at the end of 2008, according to the definitive 2019 report on private credit from the Alternative Credit Council (ACC) and law firm Dechert.

The report also forecasts a bright future for private credit, with the US and European markets pinpointed as the largest sources of potential growth over the next three years. In this context, this article aims to shed some more light on this reportedly booming asset class.

What exactly is private credit and what’s driving its growth?

Also known as private debt, non-bank lending, alternative lending or shadow lending, private credit can be described as an asset class comprised of higher yielding, illiquid investment opportunities – ranging from secured debt that is senior in the capital structure with fixed income-like characteristics, to distressed debt that displays equity-like risk and returns.

The following are the main factors that have been driving private credit’s growth:

  • The move away from traditional bank lending: Private credit has grown in leaps and bounds since 2008 on the back of banks’ reluctance to lend to smaller or riskier borrowers after the financial crisis
  • The appeal of a direct lending relationship for borrowers: From the borrower’s perspective, private credit comes with greater customisation of structures as well as longer maturity profiles to match their financing needs. They are also attracted to the private debt arena by the speed, flexibility and predictability displayed by private lenders in comparison to banks
  • Greater returns for lenders: For the lenders, the appeal of private credit boils down to the significant yield. A report on Bloomberg notes that loans in the private credit market are usually more lucrative than those to bigger or ‘safer’ companies, with all-in yields of 7%–9%, compared to ~3% for the typical investment-grade corporate bond.

Who’s lending and who’s borrowing in the private credit market?

According to Preqin (June 2019):

  • Direct lending funds accounted for 35.9% of total private debt AUM, at US$285.7 billion
  • Distressed debt constituted 25.9% of AUM, at US$206.8 billion
  • Mezzanine debt comprised 19.8% of the AUM, at US$157.5 billion
  • Special situation funds accounted for 16.5% of the AUM, at US$131.5 billion
  • Venture debt completed the picture with its contribution of 1.8% of the AUM, equating to US$14.5 billion.

In terms of lenders, while public pension funds, insurance companies and family offices have historically been the biggest investors in private credit, private equity firms have also started making inroads into the space.

The market for borrowers is also evolving. The size of private credit transactions is increasing and larger borrowers are emerging in the space. Indeed, the Preqin Private Debt Update for Q1 2020 noted that funds in the market are spread fairly evenly in terms of target size, with 16% seeking capital of under US$100 million, followed closely by 14% targeting capital in excess of US$1 billion.

Where is private credit growing?

According to Bloomberg, as at 2018, a majority of institutional investors in private credit were in North America (56%), but the field is growing fast in Europe (25%) and Asia (13%). Moreover, the aforementioned Preqin Update noted that in Q1 2020 the balance shifted somewhat. While North America accounted for just over half the capital raised, Europe moved up considerably such that funds from the region represented 46% of all funds closed.

Among the growth markets of Europe, Luxembourg is increasingly featuring as a prominent jurisdiction for private credit. Research by KPMG and the Association of the Luxembourg Fund Industry (ALFI) has shown that the proportion of direct lending strategies among Luxembourg private debt funds has almost doubled in the past year.

Besides Luxembourg, Ireland is also emerging as an attractive market for private debt funds. The Investment Limited Partnerships (ILP) (Amendment) Bill 2019, published in September 2019, holds the key to increasing Ireland’s attractiveness as a jurisdiction of choice for closed-ended funds, including private debt vehicles. Once implemented, the amended ILP bill promises to transform the investment landscape as it provides for the establishment and operation of a regulated ILP structure and can be used in conjunction with the Alternative Investment Fund Managers Directive (AIFMD) to market funds across the EU using the European funds marketing passport license/mechanism.

What lies ahead for private credit?

It has been estimated that the market size of this exciting asset class is set to exceed US$1 trillion by the end of this year, according to Bloomberg – although admittedly this prediction was made before COVID-19 took hold. However, the Preqin Q1 2020 Update notes that, while fundraising may be faltering as fund managers evaluate potential fallout from the pandemic-induced economic volatility, the number of private debt funds in the market continues to grow.

Indeed, as of April 2020, there are 457 funds seeking a combined target of US$201 billion, the highest ever recorded. This is no flash in the pan; rather, the report highlights that “the number of funds on the road has been rising consistently over the years” and this slow and steady growth has now culminated “in a fundraising market that is more crowded than ever before.”

However the coming months play out in terms of COVID-19 disruption, it seems clear that private credit is a growing asset class.

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