The democratisation of private credit

Inter­est rates remain low while infla­tion spi­rals, scar­ing any­one with sav­ings in the bank. Bull mar­kets don’t last for­ev­er, cre­at­ing stress for any investor seek­ing to shock-proof their assets. In such a con­text, few asset class­es look quite so attrac­tive as pri­vate cred­it – specif­i­cal­ly direct lend­ing – which typ­i­cal­ly pays a yield pre­mi­um to its pub­lic mar­ket alter­na­tives often with much low­er volatil­i­ty.

Direct lend­ing is a strat­e­gy where­by a com­pa­ny bor­rows mon­ey direct­ly from a pri­vate lender rather than from a bank or the syn­di­cat­ed debt mar­kets. The loan is typ­i­cal­ly senior-secured, float­ing rate and charges inter­est on a quar­ter­ly basis. Until recent­ly, how­ev­er, this was an invest­ment strat­e­gy which appeared to be avail­able exclu­sive­ly to the super-rich. Insti­tu­tion­al investors had to com­mit $10m plus min­i­mums to skilled invest­ment man­agers via funds where the cap­i­tal could be locked up for peri­ods of up to a decade.

Now, how­ev­er, a sig­nif­i­cant expan­sion in the mar­ket is lead­ing to its democ­ra­ti­sa­tion. Small­er investors have the abil­i­ty to access this strat­e­gy with low­er min­i­mums and greater liq­uid­i­ty thanks to a struc­ture known as the busi­ness devel­op­ment com­pa­ny (BDC) which has grown in pop­u­lar­i­ty marked­ly over the last 18 months.

In the last two decades, the pri­vate cred­it mar­ket has not so much expand­ed as explod­ed. Accord­ing to Pre­qin, a data and ana­lyt­ics provider on the alter­na­tive assets indus­try, assets under man­age­ment (AUM) for pri­vate cred­it reached $1.2tn by the end of 2021. For con­text, in 2000, AUM was $42bn and in 2010, $312bn. By the end of 2025, pri­vate cred­it assets under man­age­ment are pro­ject­ed to dou­ble to $2.4tn and out­strip even real estate debt.

Pri­vate lend­ing is as old as mon­ey itself but the BDC, as a finan­cial prod­uct, was born in 1980, due to leg­is­la­tion passed by the US Con­gress to help busi­ness­es raise mon­ey to scale and cre­ate jobs in the wake of an eco­nom­ic cri­sis. Busi­ness devel­op­ment com­pa­nies work by invest­ing mon­ey in pri­vate­ly owned com­pa­nies that need help to grow with the aim of gen­er­at­ing income and cap­i­tal gains; the same strat­e­gy employed tra­di­tion­al­ly by invest­ment man­agers for insti­tu­tion­al investors. Tra­di­tion­al­ly the BDC’s were list­ed on a US stock exchange allow­ing investors liq­uid­i­ty through the pur­chase and sale of the company’s shares. This, how­ev­er, also came with the down­side of expos­ing investors to equi­ty mar­ket volatil­i­ty. More recent­ly a ‘non-trad­ed’ vari­ant of the BDC has become increas­ing­ly pop­u­lar where­by investors can access liq­uid­i­ty via the abil­i­ty to redeem their hold­ing at net asset val­ue, in some instances on a quar­ter­ly basis.

The BDC mar­ket is still small in com­par­i­son to the entire indus­try but grow­ing fast. Accord­ing to the BDC Coun­cil, there are cur­rent­ly 122 in total, with over $180bn invest­ing in small- and medi­um-sized busi­ness­es across the US. Effec­tive­ly, BDCs are an inno­v­a­tive struc­ture lead­ing to the democ­ra­ti­sa­tion of pri­vate cred­it by pro­vid­ing small­er investors access to strate­gies which were cap­i­talised upon only by insti­tu­tion­al enti­ties of high net worth. Tax effi­cien­cy adds to their appeal.

HPS Invest­ment Part­ners is one of the lead­ing cred­it man­agers glob­al­ly, with more than $85bn in assets under its man­age­ment, and its analy­sis sug­gests we are at the tip of the ice­berg when it comes to the democ­ra­ti­sa­tion of the direct lend­ing mar­ket. “The tril­lion dol­lars of assets under man­age­ment in pri­vate cred­it is a rel­a­tive­ly recent phe­nom­e­non and the democ­ra­ti­sa­tion from the realm of insti­tu­tion­al cap­i­tal to the realm of non-insti­tu­tion­al investors is even more recent. [There are] two things that lie behind democ­ra­ti­sa­tion.” says to Michael Pat­ter­son, gov­ern­ing part­ner and port­fo­lio man­ag­er for direct lend­ing at HPS.

He adds: “One, there is a sig­nif­i­cant lev­el of inter­est from non-insti­tu­tion­al investors for this asset class, giv­en the attrac­tive and con­sis­tent yields that have been gen­er­at­ed by direct lend­ing rel­a­tive to oth­er cred­it instru­ments. Two, we have only recent­ly start­ed to see inno­v­a­tive struc­tures such as non-trad­ed BDC’s that allow this investor base to access pri­vate cred­it in a cost-effec­tive man­ner.”

A non-trad­ed BDC, he says, is just one of the instru­ments “that are being cre­at­ed to allow non-insti­tu­tion­al investors to access this strat­e­gy at more rea­son­able min­i­mums, with more sta­ble entry and exit prices while gen­er­at­ing reg­u­lar, sta­ble income.”

When try­ing to make sense of the cur­rent mar­ket for pri­vate cred­it it is impor­tant to exam­ine the events which led to its cre­ation. In the wake of the 2008 finan­cial cri­sis, reg­u­la­to­ry reforms, designed to pre­vent the cri­sis repeat­ing, such as Basel III, sought to strength­en risk man­age­ment in banks and penalised them for hold­ing non-invest­ment grade debt which was often pre­vi­ous­ly kept on their bal­ance sheet. This cre­at­ed a vac­u­um which invest­ment firms such as HPS were able to step into and serve as strate­gic cap­i­tal part­ners.

Since then, direct lend­ing has become a main­stream invest­ment strat­e­gy which has increased expo­nen­tial­ly over the past decade. Fur­ther­more, as spe­cial­ist cred­it firms and funds grow in size, the capa­bil­i­ty to under­write larg­er and larg­er invest­ments is also increas­ing. Pri­vate loans in excess of $1bn are already becom­ing a com­mon occur­rence in the mar­ket.

Seis­mic geopo­lit­i­cal events – includ­ing the Covid-19 pan­dem­ic, glob­al sup­ply chain issues and the war in Ukraine – explain why 2020–2022 has been such an excep­tion­al time for pri­vate debt lenders. Investors who includ­ed pri­vate cred­it and direct lend­ing in their invest­ment port­fo­lios expe­ri­enced sig­nif­i­cant­ly less volatil­i­ty from a pric­ing per­spec­tive, which meant few­er sleep­less nights. In fact, volatil­i­ty proved to be ben­e­fi­cial to firms such as HPS. In times of uncer­tain­ty, banks gen­er­al­ly don’t want to lend, and the syn­di­cat­ed debt mar­kets shut down which is anoth­er fac­tor con­tribut­ing to excite­ment over this asset class. That is not like­ly to dis­si­pate with fears of fur­ther shocks to come.

“When you go into peri­ods of height­ened risk, as we see right now,” Pat­ter­son says, “The bank-led syn­di­cat­ed mar­kets tend to pull back and that often forces larg­er bor­row­ers towards the pri­vate debt mar­ket even more than in a nor­mal envi­ron­ment.”

Pri­vate cred­it is more expen­sive for bor­row­ers because investors want a return on their cap­i­tal: BDCs pro­vide man­age­ment exper­tise to help com­pa­nies con­tin­ue to grow, devel­op and fuel acqui­si­tions. “Basi­cal­ly, on one hand, the reg­u­la­tor is push­ing this out of the remit of the banks while, on the oth­er, the mar­ket oppor­tu­ni­ty is attract­ing cap­i­tal into this asset class because yields are sig­nif­i­cant­ly high­er, and per­for­mance is more sta­ble than in oth­er asset class­es,” Pat­ter­son adds.

This year, ana­lysts pre­dict that we are like­ly to see the first $5bn pri­vate senior secured loan, pro­vid­ing yet anoth­er indi­ca­tion that the pri­vate cred­it mar­ket is on a tra­jec­to­ry to become the sec­ond largest pri­vate asset class: if democ­ra­ti­sa­tion con­tin­ues at its present pace, it won’t just be insti­tu­tion­al investors who ben­e­fit.

To find out more, please vis­it hpspartners.com

Pro­mot­ed by HPS Invest­ment Part­ners