Key Takeaways
- The private credit market has expanded in recent years as a result of banks’ stricter lending standards, reaching a size comparable to the corporate junk bond market.
- Private credit has proven to be a key avenue for raising capital for many firms that may have trouble receiving traditional bank loans or looking for increased flexibility or privacy.
- The growth of the private credit market has had a macroeconomic impact, significantly expanding the credit space in recent years. Still, incentives to make ever riskier loans and a high interest rate environment could threaten the industry.
Businesses, particularly those in their nascent stages or those seeking to expand, often require additional funding beyond what they can generate internally.
To generate this much-needed funding, many businesses choose standard credit for broader access and lower rates, enabling significant capital raising while upholding transparency and regulatory standards.
Increasingly, however, businesses are turning to private credit for their funding needs.
At the beginning of 2023, the private credit market was around $1.4 trillion, showing a significant increase from $875 billion in 2020. Projections suggest it will expand to $2.3 trillion by 2027. While the massive surge has been a boon for many businesses and investors alike, the market is still unwieldy, lacking much of the transparency and regulation of its public counterpart.
As business leaders look into new financial solutions, there are several considerations and insights they need to navigate these markets.
What is private credit?
Private credit is a broad term that applies to any private loan issued by a non-bank institution. The most common type of private credit is direct loans, which are private loans typically negotiated between the borrower and one or a small group of lenders. Institutional investors, including private equity and investment management firms, largely back direct loans.
Though direct lending is the most common type of private credit, there are other options. These include mezzanine debt, with repayment receiving lower priority in default situations. Venture debt is offered to startups based on cash flow, while financially troubled companies, along with special situations, can be extended what is known as distressed debt.
In the wake of the 2008 financial crisis, banks faced increased regulations which caused them to decrease their lending activity. In the years since, private credit providers have stepped in to fill the void. By 2023, the private credit market was estimated to have reached $1.4 trillion, similar to the publicly traded junk-rated corporate bond market.
2020 saw a spike in private credit loans as near-zero interest rates made capital cheap. In the wake of the collapse of Silicon Valley Bank and a few other regional banks in 2023, private credit stepped in as a source of capital as bank lending contracted. The private credit market has seen continued growth even as high interest rates have caused banks to retreat from lending, and companies have been refinancing leveraged loans with more flexible private credit agreements.
Why are firms choosing private credit?
Private credit comes with distinct advantages that have driven the sector’s growth in recent years:
1. Flexibility
Private credit providers often offer more flexible terms compared to traditional lenders like banks. This can include customized repayment schedules, covenant flexibility, and tailored financing solutions to meet specific business needs. Direct loans are indeed increasingly covenant-lite loans, which are loans with fewer restrictions.
2. Speed
Private credit transactions typically involve less bureaucracy and can be executed more quickly than traditional bank loans. This can be crucial for businesses needing fast capital access to seize opportunities or address urgent needs. Direct loans are often priced up front, while traditional bank loans can change in price over a deal.
3. Access to capital
Private credit can provide financing options for businesses that may not qualify for traditional bank loans due to factors such as limited operating history, unconventional business models, or credit issues.
4. Diverse funding sources
Private credit encompasses a wide range of lenders, including direct lending funds, private equity firms, family offices, and alternative lenders. This diversity can increase the chances of finding a suitable financing partner with terms that align with the business's objectives.
5. Protection from defaults
Lower regulations allow direct loans to be amended and extended in cases that may otherwise result in default. Many direct lending deals are also made to companies owned by private equity firms who can step in to support companies in danger of default. Institutional investors also tend to focus private lending on markets with a high level of market expertise.
6. Decreased regulatory burden
Private credit providers are often subject to limited regulatory oversight compared to traditional banks, which can result in fewer regulatory hurdles and faster decision-making processes.
While private credit comes with a litany of advantages for the lender and borrower, it’s also important to consider its downsides:
1. Higher cost
Private credit financing typically comes with higher interest rates and fees compared to traditional bank loans. This can increase the overall cost of borrowing for businesses, especially those with weaker credit profiles. Many private credit loans are floating rate, meaning payments move along with the prevailing interest rate. This could become an issue as the Federal Reserve continues to hold interest rates high.
2. Diminished transparency
Private credit transactions may involve complex structures and terms that are not always transparent to borrowers. These transactions can make it challenging for businesses to fully understand the costs and risks associated with the financing. The nature of the private credit industry also means less regulation and fewer protections for borrowers.
3. Limited recourse
Private credit agreements may include stricter terms and less recourse for borrowers compared to traditional bank loans. This can expose businesses to higher default risks and potential loss of control over assets in the event of financial distress.
4. Less established relationships
Unlike traditional banks, which often have long-standing relationships with their clients, private credit providers may have less history with the individual businesses they finance. This can result in less personalized service and support for borrowers.
5. Dependency on market conditions
Private credit markets can be sensitive to economic conditions and investor sentiment changes. . During periods of market volatility or economic downturns, private credit providers may tighten their lending criteria or reduce the availability of financing, making it harder for businesses to access capital when needed.
Who should turn to private credit?
Startups and early-stage companies
Private credit can provide a lifeline to startups and early-stage companies without the track record or assets to qualify for bank loans. These businesses often require flexible financing solutions that align with their unique growth trajectories. Even firms with poor credit can benefit from private credit, as it addresses the demand for investments that are traditionally considered riskier.
Middle-market and non-traditional firms
For middle market firms that are not large enough to participate in the corporate bond market, private credit can serve as one of the few available sources of capital. Similarly, businesses operating with non-traditional business models or unconventional revenue streams may face challenges securing financing from traditional banks. Private credit providers offer more customized solutions that consider these industries' specific risks and opportunities.
Companies needing quick access to capital
Private credit can offer speed and flexibility when businesses require rapid access to capital for time-sensitive opportunities or unexpected challenges. . Whether seizing a growth opportunity, financing a strategic acquisition, or addressing a cash flow shortfall, private credit allows quick access to capital without the lengthy approval processes typical of traditional bank loans. Unlike standard bank loans, private credit deals tend to have upfront pricing, which reduces uncertainty.
Businesses with variable cash flows
Private credit can provide a more suitable financing option for companies with variable cash flows. Seasonal or cyclical revenue streams can be better accommodated with private credit, as repayment schedules and covenant structures offer greater flexibility. This helps smooth out cash flow fluctuations and provides stability during uncertain periods.
Highly leveraged firms
In the current high interest rate environment, highly leveraged firms can turn to private credit firms to refinance loans approaching maturity. Private credit loans are often made on more flexible terms and may involve interest payments made with additional debt.
Key considerations and actionable strategies:
Evaluate the cost-benefit analysis: While private credit offers faster access to capital and increased flexibility, it often comes with higher costs compared to traditional bank loans. Floating interest rate loans also expose firms to potential runaway costs if interest rates rise. Businesses should carefully assess the overall cost of borrowing and weigh it against the benefits of flexibility and speed.
Seek transparent and fair terms: Given the potential complexity and lack of transparency in private credit transactions, businesses should work with reputable lenders who are transparent about their terms and fees. Negotiating appropriate terms and understanding the implications of covenant structures is crucial to avoiding unexpected costs and risks.
Build relationships with multiple providers: Diversifying funding sources can mitigate risks associated with dependency on a single lender or funding channel. Businesses should proactively cultivate relationships with multiple private credit providers to ensure access to capital under various market conditions.
Consider equity alternatives: In some cases, businesses may explore alternatives such as mezzanine financing or convertible debt offered by private credit providers. These structures can provide access to capital without increasing fixed debt obligations, allowing for greater flexibility in managing cash flow and growth initiatives.
Who should turn to standard credit?
Established businesses with strong financial profiles
These businesses have solid financial track records, substantial assets, and predictable cash flows. They are well-suited for traditional bank loans. With their leverage, they can negotiate favorable terms and lower interest rates. Larger companies can also raise funds by issuing corporate bonds.
Large-scale capital projects
Businesses involved in significant capital projects like infrastructure investments or real estate developments may benefit from public credit markets or government-backed financing programs. These options typically offer longer tenures and lower interest rates. In the transition to green energy, companies will require substantial capital.
Companies seeking lower cost of capital
Businesses with strong credit profiles and access to public credit markets may find public debt offerings or bond issuances more cost-effective for raising capital compared to private credit or equity financing.
International expansion and cross-border transactions
Businesses engaged in international expansion or cross-border transactions may prefer traditional bank loans or public credit offerings. They are familiar with global banking systems and regulatory environments, making these financing options more suitable. These options provide access to capital in multiple currencies and jurisdictions, facilitating seamless expansion initiatives.
Key considerations and actionable strategies:
Maintain strong financial discipline: To qualify for traditional bank loans or public credit offerings, businesses must demonstrate strong financial discipline, including healthy cash flow, manageable debt levels, and a solid repayment track record. Maintaining transparent financial reporting and a strong credit history is essential.
Explore government-backed programs: Businesses undertaking projects with significant social or economic benefits may qualify for government-backed financing programs or public-private partnerships. Exploring these options can provide access to lower-cost capital and additional support for large-scale initiatives.
Diversify funding sources: While traditional bank loans may offer favorable terms for established businesses, it's essential to diversify funding sources to mitigate risks associated with changes in lending conditions or market dynamics. Leveraging a mix of bank loans, public debt, and private credit can optimize the cost and availability of capital.
Manage currency and interest rate risks: Managing currency and interest rate risks is critical for businesses engaged in international transactions or exposed to currency fluctuations. Utilizing hedging instruments such as forward contracts or interest rate swaps can help mitigate these risks and ensure stable cash flow management.
Final Word
Private credit has proved to be a viable alternative to public credit, expanding the credit space by providing a source of funding to firms that may otherwise struggle to find it and by providing loans in a more efficient, personal and private manner.
The rising availability of flexible financing via private credit has had a macroeconomic impact; some observers have pointed to the sector as a contributing factor to continued macroeconomic growth even as steadily rising interest rates have slowed banks’ lending activities. Still, if private credit is playing an outside role in recent growth, the question remains as to what a potential collapse of private credit may look like.
Private credit, by nature, lacks transparency. If the system is in trouble, it may only come to light once it is too late. As the private credit market continues to expand, competition will increase, and lenders will be incentivized to give increasingly risky loans. Still, possibilities aside, the reality of previous years has seen private credit being able to provide certain types of credit efficiently in a way that banks could not, earning its growth.
