Understanding Private Credit

Demand for private credit—which refers to lending to companies by institutions other than banks—has grown significantly in recent years. Unlike most bank loans, private credit solutions can be tailored to meet borrowers’ needs in terms of size, type or timing of transactions. Similar to bank loans, however, the majority of private credit lending is in the form of floating-rate investments that change as rates change, providing real-time interest rate mitigation compared to investments like fixed-rate bonds.

In addition, amid recession fears and tighter bank lending, private credit offers borrowers pricing certainty and speed, which has helped fuel the market’s growth in recent years. The size of the private credit market at the start of 2024 was approximately $1.5 trillion, compared to approximately $1 trillion in 2020, and is estimated to grow to $2.8 trillion by 2028.¹

Ashwin Krishnan, Co-Head of North America Private Credit at Morgan Stanley Investment Management, explains the different types of private credit, the growing appetite for the asset class and how private credit has behaved in prior market cycles.

Krishnan: Private credit is a form of lending outside of the traditional banking system, in which lenders work directly with borrowers to negotiate and originate privately held loans that are not traded in public markets. Following the Global Financial Crisis (GFC) in 2008, and the associated capital rules for banks, private credit has filled a lending void.

There are generally four common types of private credit²:

• Direct Lending: Direct lending strategies provide credit primarily to private, non-investment-grade companies. Direct lending strategies may be appealing as they invest in the senior-most part of a company’s capital structure, which may provide steady current income with relatively lower risk.   
• Mezzanine, Second Lien Debt and Preferred Equity: These three forms of credit, collectively known as “junior capital,” provide borrowers with subordinated debt. This kind of instrument is not secured by assets and ranks below more senior loans for repayment in the event of a default or bankruptcy. Junior capital often comes with equity “kickers,” which are incentives that can support attractive total returns—often on par with equities—while still being a debt claim in the payment waterfall.
• Distressed Debt: When companies enter financial distress, they work with existing distressed debt investors to improve their prospects through operational turnarounds and balance sheet restructuring. Distressed debt is highly specialized and the prevalence of opportunities tends to coincide with economic downturns and periods of credit tightness. These lenders take on a higher level of risk in exchange for lower prices and potentially high returns.
• Special Situations: Special situations can mean any variety of non-traditional corporate event that requires a high degree of customization and complexity. This may include companies undergoing M&A transactions or other capital events, divestitures or spinoffs, or similar situations that are driving their borrowing needs.

Krishnan: Investors have increasingly added private credit to their portfolios as a potentially higher-yielding alternative to traditional fixed-income strategies. It can potentially include the following: 

• Current income: Like traditional fixed income, private credit generally offers the possibility for current income from contractual cash flows (i.e., interest payments and fees).
  
• Illiquidity premium: Private credit may provide a yield spread above public corporate bonds to compensate for the “illiquid” or non-tradeable nature of the investments.
• Historically lower loss rates: Private credit has demonstrated lower loss rates relative to public credit over time.
• Diversification: Private credit has been less correlated with public markets than other asset classes, such as equities and bonds. This can help reduce portfolio volatility and improve risk-adjusted returns.
• Customized portfolio construction: It may be possible to create highly customized portfolios of strategies to blend risk-adjusted returns across a variety of private-credit strategies. 

Krishnan: Private credit has historically offered compelling performance in relation to other segments of the fixed-income market. Since the global financial crisis, when private credit began growing in earnest, direct lending (the most common type of private credit) has provided higher returns and lower volatility compared to both leveraged loans and high-yield bonds.^3,4

High Returns Relative to Volatility ^4,5

In particular, direct lending has outperformed in high and rising rate environments. When measured over seven different periods of high interest rates between the first quarter of 2008 and the third quarter of 2023, direct lending yielded average returns of 11.6%, compared with 5% for leveraged loans and 6.8% for high-yield bonds.^4,5

Direct Lending's Outperformance in High Interest Rate Environments ^{4, 5, 6}

Private credit may also offer better mitigation against losses, having demonstrated relative resiliency during the COVID-19 pandemic. Between the outbreak of COVID and the third quarter of 2023, direct lending sustained losses of 1.1%, compared with losses of 1.3% for leveraged loans and 2.2% for high-yield bonds.^{5, 7}

Direct Lending's Fewer Losses During COVID-19 ^{4, 5, 7}

Krishnan: We see the potential for opportunities in the following areas:

1. Providing junior capital and hybrid capital solutions, as today’s “higher for longer” interest-rate environment constrains fundamentally-sound businesses with higher cash debt service requirements and lower levels of senior debt capacity. Junior capital can help relieve those fixed obligations and allow companies to pursue accretive organic and inorganic growth initiatives.
2. Extending credit to high-quality growth companies. In the wake of rising benchmark rates, many equity investors reoriented their focus away from “growth at any cost” enterprises and toward stable, profitable companies. Consequently, the availability of growth capital for ramping, high-quality businesses—many with best-in-class KPIs—dried up. There is an opportunity to fill this gap in a way that allows high-quality companies to re-invest earnings at attractive incremental returns with minimal equity dilution, while generating attractive returns for the investor.
3. Rescue-financing capital, should the economy enter into a recession or high-default environment. 

Krishnan: A proactive approach has become increasingly important, which includes closely analyzing companies’ earnings and free cash-flow generation in light of the current economic and interest-rate environment.

Meanwhile, for companies, the primary focus is liquidity management. Borrowing costs have increased significantly over the last 18 months, as loans are a floating-rate product. To date, the vast majority of borrowers in the market have been able to successfully manage their liquidity.