Private creditis an asset defined bynon-banklendingwhere thedebtis not issued or traded on thepublic markets.Private creditcan also be referred to as "direct lending" or "private lending". It is a subset of "alternative credit". The private credit market has shifted away from banks in recent decades. In 1994, U.S. bank underwriting covered over 70 percent of middle market loans.By 2020, U.S. banks issued/held around 10 percent of middle market loans.
Direct lending market expanded rapidly in the wake of the 2008 financial crises when the SEC tightened restrictions and capital requirements on public banks. As banks decreased their lending activity, nonbank lenders took their place to address the continued demand for debt financing from corporate borrowers.Private Credit has been one of the fastest-growing asset classes.By 2017, private debt fundraising exceeded $100B.One factor for the rapid growth has beeninvestordemand.
As of 2018, returns were averaging 8.1% IRR across all private credit strategies with some strategies yielding as high as 14% IRR. At the same time, supply has increased as companies have turned to non-bank lenders after thefinancial crisis due to stricter lending requirements.One recent trend has been the rise of covenant-lite loans (which is also an issue for publicly traded investment grade and high yield debt). This has been driven by investor demand for the relatively high yield compared to alternatives and a willingness to accept less protections.
This has resulted in fewer company restrictions and fewer investors' rights if the company struggles. That being said, for the investment firms, covenant-lite loans can also be helpful because of the negative optics if aportfolio company goes into default, and fewer restrictions means fewer ways a company can go into default.In addition to private funds, much of the capital for private debt comes frombusiness development companies(BDCs).
BDCs were created byCongressin 1980 as closed-end funds regulated under theInvestment Company Act of 1940to provide small and growing companies access to capital and to enable private equity funds to access public capital markets. Under the legislation, a BDC must invest at least 70% of its assets in nonpublic US companies with market value less than $250M. Moreover, likeREITs, as long as 90% or more of the BDC’s income was distributed to investors, the BDC would not be taxed at the corporate level.
While BDCs are allowed to invest anywhere in the capital structure, the vast majority of the investment has been debt because BDCs typically lever their equity with debt (up to 2X their equity), and fixed income investing supports their debt obligations. With regards to size of the market, as of June 2021, BDC assets totaled $156 billion from 79 funds.
Over 70% of the investor capital for private credit comes from institutional investors.For n on-institutional investors looking to invest in private capital, few options exist because most of the investment vehicles are private and limited to qualified investors ($5M or more liquid net worth). As of June 2021, 57% of the BDC market was publicly traded BDCs where retail investors can invest.
Over the past 10 years (through 2022), private credit, tracked by the Cliffwater Direct Lending Index–Senior Only,9 has returned 7.8%, on average, versus 4.1% for the J.P. Morgan Leveraged Loan Index, its closest comparison.
The returns from private debt compare favourably to those of public debt. Understandably investors want to be compensated for the illiquidity that features where there is no tradable market for their investment. This means private debt investments tend to pay higher yields.
Private equity is an attractive investment option for high-net-worth individuals and institutional investors because of its potential for high returns. Private equity falls under the category of alternative asset classes.
The investment seeks investment results that correspond the price and yield performance of the Indxx Private Credit Index (the "underlying index"). Under normal market conditions, the fund will invest not less than 80% of its assets in component securities of the underlying index.
Another downside of private credit investing is the high costs associated with the asset class. Because private credit transactions are typically done directly between investors and borrowers (rather than through a public market), they can involve high fees for both parties.
Private credit may be appropriate for investors seeking relatively stable and predictable returns that often exceed those of bonds and other fixed-income assets. Private equity could be suitable for those in search of high potential returns, although this also means elevated risks.
The Federal Reserve's May 2023 Financial Stability Report described the financial stability risks from private credit funds as low, in part because investors in private credit (unlike bank depositors) are required to lock up their money for five to 10 years.
For example, consider the purchase of a property with $300,000 NOI and a loan of $3 million. In this example, the debt yield is 10 percent ($300,000 / $3,000,000 = 10%).
In the environment of inflation and rising interest rates, higher interest payments on floating-rate debt could stress borrowers' balance sheets, leading to a significant increase in defaults in an economic downturn.
According toCambridge Associates' U.S. Private Equity Index, PE had an average annual return of 14.65% in the 20 years ended December 31,2021. In comparison, theCambridge Associates U.S. Venture Capital Index found that VC returns averaged 11.53% in the same 20-year period.
The required minimum investments are often as high as $25 million, and the Securities and Exchange Commission (SEC) only allows “accredited investors” to participate.
What are the cons of private equity investing? Private equity investments are illiquid: Investor's funds are locked for a certain period. As such, investors in private equity must have a long-term investment horizon and be willing to hold their investments for a few years, if not more.
The leverage loan index provides the best fit as a benchmark across most private credit strategies. Measures of relative performance (PMEs) suggest that private credit funds have performed about as well, or better than, leveraged-loan, high-yield, and business development company indexes.
While a private equity fund may generate returns by increasing the value of the company it invests in, a private credit fund's returns are achieved primarily through its receipt of interest on the loans it extends and through the sale or repayment of such loans.
Houlihan Lokey is an expert in the valuation of private credit, including direct lending and BDC assets. We produce the index, studies on relevant topics, and other research and analyses.
According toCambridge Associates' U.S. Private Equity Index, PE had an average annual return of 14.65% in the 20 years ended December 31,2021. In comparison, theCambridge Associates U.S. Venture Capital Index found that VC returns averaged 11.53% in the same 20-year period.
While the typical preferred return in private equity is 8%, it is often 6–7% in the case of private credit funds, which usually have lower target returns than buyout funds. Note that venture capital funds do not typically offer a preferred return.
Reliable Cash Flow: While there are no guarantees, private money lenders can typically expect an annual return somewhere between 8% and 10%. Depending on the loan structure, there may be other ways in which profits are realized, like interest.
Most private credit direct lending is generally for maturities of five-to-seven years; this is similar to leveraged loans, although in most cases these are refinanced well in advance of the actual maturity date.
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