The Times They Are A Changin’
The three pillars of Private Credit have evolved from 1) Middle Market Lending, 2) Lower Middle Market Lending and 3) Upper Middle Market Lending to a broader, larger TAM that is worthy of consideration. Capital allocators have greater flexibility with a strong potential for enhanced returns by optimizing and diversifying their portfolio of Private Credit holdings. Key to select upper-quartile, experienced managers, however the approach to strategy that has prevailed during the past 10 years, may not be optimal in the years to come.
Looking forward, Private Credit will be defined differently. Direct Lending will continue to receive allocations, however Asset-Based Lending will begin to take a larger share of the growing pie. ABL is huge, the TAM is measured in tens-of-trillions and I believe will grow to be as large as Direct Lending in 10-years’ time. Marathon Asset Management has been actively running its ABL strategy for the over 15 years and as an incumbent and experienced ABL manager we see firsthand how this market is developing. Basel III-Endgame will advance the development of Private Credit ABL just as Basel III enabled private credit managers to capture market share for Direct Lending over the past 15 years since the GFC.
As the global economy grows, both Direct Lending and ABL will benefit as they form the 2 key pillars of the Private Credit market. The 3rd leg of the Private Credit stool are Opportunistic Strategies, defined as Capital Solutions, Dislocation & Distressed. Capital Solutions are a critical component to lending allowing for both growth capital as well as bridge capital during times of stress or transition for a company. Capital solutions may require a turn of extra leverage, carrying significantly higher coupons (~200bp+), +warrants supported by super-strong covenant package that can provide the lender with higher IRRs and MOICs.. Given current market conditions, capital solutions are a key component for any opportunistic lending program. As companies go all out to avoid BK, distressed exchanges have added to the opportunity set, as new money solutions enable companies to exploit weak documentation within credit agreements lenders previously accepted. Today, Opportunistic Credit is robust and I see as many opportunities in Capital Solutions as I do in special situations and dislocation.
The right combo for a Private Credit portfolio might be 40% Direct Lending, 40% Asset-Based Lending & 20% Opportunistic Credit. Private Credit performance is remarkably consistent with lower volatility relative to most alternative assets.
Porfolio Construction is always top of mind for me - how would you build your Private Credit portfolio? What strategies, which managers, how big of an allocation across a balance book that includes Public Debt, Public Equities and Alternatives? Private Credit in aggregate is approaching $5T across various strategies. I believe it will 3x ($15T) in 10-years.
