Borrowers Beware

Private credit is the flavor of the month among the world’s financial elite. Corporate borrowers should think carefully before tasting.

Big US and European banks, whose lunch is being nibbled (if not gobbled) by private credit providers, are trying to join the private lending crowd—albeit at arm’s length—via nonregulated partners or subsidiaries. Citigroup is the latest to announce a private credit initiative, joining US rivals JPMorgan Chase and Wells Fargo, and European behemoths Deutsche Bank and Societe Generale, among others. Investment banking icon Goldman Sachs announced in December that it will double its private credit operation.

Established players, headed by large private equity (PE) funds, are eager to crow. Private credit has entered a “golden moment,” Jonathan Gray, president of Blackstone, declared on an earnings call last April. On a third-quarter earnings call, competitor Michael Arougheti, CEO of Ares Management, lauded “risk-reward characteristics that are as favorable as we’ve seen in many years.”

As the name suggests, private credit refers to corporate finance raised confidentially through nonbank lenders, typically by a few of them teaming up. Average loan size has grown to $195 million, from $135 million before the Covid-19 pandemic, according to Ramki Muthukrishnan, head of US leveraged finance at S&P Global Ratings.

Banks would have provided these loans before the 2008-2009 global financial crisis (GFC). Regulators across the globe have pushed them away since then, raising risk ratios for credit not collateralized by hard assets and discouraging the leverage levels often associated with corporate buyouts.

“Private credit was an established but sleepy part of the private markets before the GFC,” says Gregory Brown, research director at the Institute for Private Capital of the University of North Carolina (UNC). It has mushroomed as regulators push to get “some of that risky stuff off banks’ balance sheets.”

Tempting Margins

It’s easy to see why banks and other lenders want to get back into the game. Interest on private credit runs two to three percentage points above competing instruments like high-yield bonds or traded leveraged loans, says Jeffrey Griffiths, co-head of global private credit at London-based adviser Campbell Lutyens. Currently, that translates to 10%-12% annually, the kind of yield you would find in C-rated junk bonds or financially shaky foreign governments. Private credit borrowers, however, are solidly managed corporations on firm financial footing—at least, they are supposed to be.

The 10% figure also nearly matches the average return from the S&P 500 index of US stocks since it was created in 1957. So, in broad theory, private credit is a category of debt offering similar returns to equity but with a different risk profile, a sort of financial alchemy.

Most private credit deals also involve variable interest rates, which of course soared as the US Federal Reserve and European Central Bank hiked rates over the past two years. That’s fattened lenders’ profits even as conventional fixed-rate bonds and loans plunged in value.

Banks won’t be able to offer private credit directly. Instead, they have floated potential partnerships with less-regulated entities, or they’ve used their giant client bases to originate transactions that a private credit partner would fund.

That could be a big deal, bringing in a wider spectrum of borrowers and making rates a bit more competitive. “Banks have excellent networks from an origination perspective,” Griffiths says.

Winners and Losers

Although lenders celebrate fat margins in private credit, borrowers may be suffering from them. Interest rate premiums and payments are ratcheting up under tighter central bank policy. S&P provides credit ratings for some 2,000 “middle-market collateralized loan obligations,” a term largely synonymous with private credit loans, Muthukrishnan says. Of these, 175 (8.75%) were downgraded during the first nine months of 2023, a sharp increase from the previous year. “Two or three years ago, our concern was high leverage,” he says. “Now it’s interest cover.”

Companies may turn to private credit anyway, for short-term financing that no one else will offer. Two examples come from Michel Lowy, a co-founder of investor SC Lowy, based in Hong Kong. His firm helped finance a South Korean hotel, apartment and casino complex that opened during the pandemic, tiding it over until better times. The firm also sourced funds for the owner of an Indian cement factory who wanted to buy out his partner. “They wanted to use equity as collateral, which Indian banks couldn’t do, from a regulatory standpoint,” Lowy explains.

Interest on these loans runs anywhere from 12%-20%. “It’s expensive financing, but it often works as a one-to-three-year bridge,” Lowy adds. Asia is a laggard in private credit, but he sees it as the fastest-growing region going forward.

The large majority of private credit loans, though, are sponsored deals, arranged by PE investors who partner with or control the underlying corporate borrower. These same PE players—Blackstone, Ares, Apollo Global Management, and others—are also active as lenders, though presumably on different transactions. Indeed, private credit has become the go-to solution for the PE industry, providing about 80% of its financing, says Karen Simeone, a Boston-based managing director at private market specialist HarbourVest.

“Private credit has been flavor of the month for seven or eight years,” UNC’s Brown summarizes. “It’s just entering the mainstream now.”

With those steady tailwinds, the market has grown steadily at around 20% a year, reaching an estimated $1.5 trillion in loan volume globally. The US is the center of the business, with European deal volume at about half of North American levels, Campbell Lutyens’ Griffiths estimates. A few blockbuster private credit deals, in Europe as it happens, have grabbed headlines. A cabal of US funds raised $5.3 billion to buy London-based Finastra, a self-described fintech powerhouse, in July. Blackstone and UK-based Permira Credit nearly matched that in November, raising €4.5 billion (about $4.9 billion) to buy Norwegian online classifieds platform Adevinta.

But private credit’s core borrowers remain, as S&P’s rankings suggest, midsized companies, by global capital standards. “Private credit is very relevant to firms with annual Ebitda [earnings before interest, taxes, depreciation, and amortization] of $10 million to $50 million, maybe up to $100 million,” Griffiths says. “Banks would make those loans pre-GFC. Now CFOs have to look for alternatives.”

Advantages of Privacy

There are reasons to turn to private credit even when alternatives exist. Issuing a bond or leveraged loan may be cheaper, but private credit can be faster and simpler. “There’s no investment bank or road show,” S&P’s Muthukrishnan says. “There’s more certainty that the deal will get done, not fall apart in syndication.”

Private credit lenders are more like business partners and less like bankers tied up with red tape. That can increase flexibility when the loan terms are drafted: an optional second tranche held in reserve, for instance. The partnership can also help if the borrower hits a rocky patch, says Daniel Roddick, founder of London-based Ely Place Partners, which raises capital for private credit funds. “These loans are not binary on performing or defaulting,” he explains. “There’s typically close cooperation between the sponsor and the company to  work through any difficult periods.”

Last, but not least, private credit is not public. “A great part of this market is opaque,” says Muthukrishnan. “Sponsors and issuers both prefer it that way.”

In theory, private credit can also match pools of stable long-term capital, held by institutional investors and family offices, with longer-term capital needs of growing corporations. Insurance companies or pension funds, the typical limited partners that funnel cash to private credit funds, are much less levered than banks and don’t face the threat of a run on deposits. “I think regulators are pleased,” Griffiths says. “It’s preferable that corporate lending be done outside of banks.”

Midterm Rate Risks

In practice, though, most private credit is used as medium-term debt, to be paid off when the PE sponsor exits the borrower through a sale or public stock offering. The average loan is held for three years, HarbourVest’s Simeone says, though contracted maturities are more like seven years.

That’s a problem, as higher interest rates and resulting lackluster markets make exits harder to find. The value of global mergers and acquisitions, one key indicator of the exit climate, dropped by a third in 2022 to its lowest in a decade excepting the 2020 pandemic year. It declined again in the first half of 2023.

If sponsors cannot sell or float as quickly as they had hoped, they may need to roll over their private credit lines at higher interest. “Private equity companies that are finding it difficult to exit companies may need to refinance instead,” Roddick says.

PE firms may also be tapping private credit to pay back their own investors who are pressing to get some money out. “General partners need to find ways of distributing capital to their limited partners,” explains Roddick.

Stress on the system is aggravated by two more factors, an economic slowdown that is well underway in Europe and threatening in the US could squeeze borrowers’ ability to repay and a flood of would-be new lenders may be chasing increasingly risky deals. “There’s enough froth in the market that there’s got to be some folks who have been making bad underwriting decisions,” warns UNC’s Brown.

A revival of animal spirits in M&A or initial public offerings could bail lenders out. That hopeful turn of events looks more likely after 2023’s stock market rebound, with interest rates probably peaking. If not, things could get ugly. “If the exit market doesn’t thaw over the next year or two, you may see a wave in distressed private credit,” Brown says. “The music is going to stop at some point.”

S&P’s Muthukrishnan sees a similar time frame. “From a liquidity standpoint, the next year or two is OK across the market,” he says. After that, not so much.

Here Come The Banks

The rush of leading commercial banks into private credit, in both North America and Europe, could alter the landscape for better or worse. Deep-pocketed newbies with money to burn might disrupt an “everybody-knows-everybody” business where trust builds up from one deal to the next. But the likes of JPMorgan Chase and Societe Generale could also extend private credit beyond PE-backed borrowers and produce hybrid deals that might be cheaper.

Regulated banks might use their own networks to recruit borrowers, then “take the most senior secure piece of the credit package,” Campbell Lutyens’ Griffiths speculates. Private credit could provide the riskier chunk. Banks can enhance packages with a range of services PE sponsors cannot provide, from corporate credit cards to foreign exchange.

Private credit certainly has its place for corporates who need short-term funding in a hurry, or the sorts of “special situations” on which Michel Lowy says he focuses. In most cases, beneath the excited headlines, private credit is the latest way of piling leverage into leveraged buyouts. That process has been controversial since Michael Milken pioneered junk bonds in the 1980s. The world’s top regulatory bodies steered licensed banks away from this lending 15 years ago, leaving a market for buyers, and even more so borrowers, to beware. So, beware.