By Hirofumi Takeuchi and Momoe Ban
A series of failures of mid-sized U.S. banks and the bailout acquisition of Credit Suisse by UBS have led to a petit credit crunch in the U.S. as banks have tightened their lending stance. Amid this situation, the growing presence of private credit, in which funds provide loans directly to companies, appears to be a key driver of the credit market in the U.S. Ample funds and flexible terms attract borrowers. The financial authorities are wary of the expansion of "shadow banking," which is less regulated, but the fund industry is eager to take advantage of it. Will they be able to fill the credit void left by the decline of the banking sector and leapfrog to a leading role in corporate finance?
"This is really the golden age for private credit," Douglas Ostrover, Chief Executive Officer of Blue Owl Capital Inc., which has $68.6 billion in assets under management in the private credit, told NIKKEI Financial. “I thought there was no way we could take that market share from the banks. But today, we are. These are big world-class businesses. What we try to do for the most part is finance big companies that are number 1, 2, 3, maybe 4 in their sector."
Even before the March 10 collapse of Silicon Valley Bank (SVB) created fissures in the banking system, the Federal Reserve's rapid monetary tightening had reduced banks' credit capacity. According to research firm Leveraged Commentary and Data (LCD), U.S. funding of leveraged loans, loans to companies with low or no credit rating, fell 63% year over year to $225.2 billion in 2022.
Leveraged loans, which are typically financed by a syndicate of multiple banks, are often sold to institutional investors to transfer risk to outside parties. However, the sale of loan assets that supported Elon Musk's acquisition of Twitter and investment funds' acquisition of Citrix Systems, an information technology (IT) company, has not been successful due to the deterioration of market conditions caused by monetary tightening, and banks have been cautious about originating new leveraged loans.
In contrast, private credit is growing, with LCD estimating that loans totaled $200 billion in 2022, up 28% from the previous year and approaching leveraged loans, and with the SVB collapse making banks more reluctant to lend, there may be a shifting of the lead role in providing funds to less creditworthy companies.
Private credit is also called "private debt." The main type of private credit is direct lending, in which funds lend directly to small and mid-size companies without involving banks. According to research firm Preqin, the total assets under management of private credit, including subordinated loans and loans to companies that are at risk of bankruptcy, has grown to $1.33 trillion.
The main growth driver is financing for LBO deals by investment funds. According to the LCD summary, most LBO deals in the second half of 2010 were backed by private credit.
Thoma Bravo, an investment fund specializing in investments in software companies, is one of the pioneers in the use of private credit. According to Erwin Mock, Head of Capital Markets, the company has been using private credit exclusively for its LBO deals since 2021, with a few exceptions. The company raised more than $2 billion from 19 direct lending funds in the acquisition deal of Coupa, an accounting software developer, which was completed in February 2023.
While bank loans are often lower in terms of simple funding costs, there are subtle differences in terms of usability. Loans tend to take longer from syndicate formation to loan execution, and conditions can change as the external environment changes. Another feature of private credit, Mock explains, is the flexibility of terms and conditions tailored to software companies, many of which are subscription-based service providers. “If we want to do deals that are ARR loans. We have to do it in the private debt market," Mock said.
And at present, the leveraged loan market is dysfunctional. "Frankly, the syndicated market is not at a point where we're able to do new leveraged buyouts," Mock said.
There is a strong expectation in the industry that private credit can also meet a wide range of funding needs other than LBO deals. Rob Bolandian, Co-Founder & Global Head of Investment Banking of Cambridge Wilkinson, said, "Given the troubles that banks are having now, they're lending less and less, which creates a gigantic void in credit. This credit void must be filled somewhere, and private credit is incredibly well suited."
White Oak Global Advisors, with just under $10 billion in assets under management, has identified lending to small and medium-sized businesses, which are not private equity (PE) fund portfolio companies but are targeted by general banks for lending, as a growth area, and has been strengthening its lending activities in the form of loans backed by movable assets (ABL) secured by accounts receivable, inventory, and machinery and equipment.
Darius Mozaffarian, Partner & President, said, "We believe that the bigger opportunity here is to continue focusing on the taking C&I lending market share away from the banks due to increased regulation in light of SVB going bankrupt and the impact that that's going to continue to have on commercial industrial lending across the globe."
In a report dated April 3, Goldman Sachs analyzed how private credit is likely "to play a greater role in financing the economy beyond the industry’s traditional roots of sponsor-backed leveraged finance." The report points out that publicly traded companies engaged in private credit, such as Apollo Global Management, Blackstone, and Blue Owl Capital, could benefit.
Of course, skepticism persists. Christina Padgett of Moody's, a major credit rating agency, said, "I don't believe direct lenders can fill the gap completely.” As the economic downturn makes the earnings environment less predictable, "they're going to be as selective as anybody else," she predicted.
Ostrovar, CEO of Blue Owl Capital, also acknowledges that "quantity [of lending] will be down" in 2023 due to a slowdown in M&A. On the other hand, he also predicted that "quality is far greater than anything we could have imagined."
Pension funds and university endowments that invest in private credit funds are closely watching the impact and opportunities presented by the current credit market turbulence. They have been gradually increasing their holdings in what they hope will be a new area of alternative investments.
According to Preqin's summary, private credit accounted for 3.8% of North American pension funds' total assets in 2022, the highest since it began compiling the data in 2015. Arizona State Retirement System allocates more than 20% of its total assets to private credit.
Oliver Fadly, Head of Private Debt Investments at NEPC, a pension consulting firm, has had many conversations with pension fund managers since the SVB collapse. "There are heightened concerns, but I haven't seen anyone [in clients] stop allocating," he said. In fact, many clients see the higher volatility as an opportunity to invest.
In fact, there have been moves to increase allocations even as the credit markets continue to be shaken. The Illinois Municipal Retirement Fund announced on April 3 that it is soliciting proposals from private credit managers. They intend to invest at least $300 million in this area. The University of California’s investment fund also announced on March 16 that it plans to increase its allocation to private credit.
The rapid expansion of private credit, a type of shadow banking, is widely believed to be a disruptive factor in the financial system in the medium to long term.
A section of the Global Financial Stability Report (GFSR), released on April 4, noted that private credit is "largely opaque" and "driving an accumulation of asset quality performance risks that may be hard for market participants and regulators to discern until it is too late to counteract." The report also summarized that "private credit is a relatively new asset class, with performance untested in a prolonged economic downturn."
Mr. Fadly of NEPC believes that there is no indication at this point that the borrowers have difficulties repaying the debt, but he added, "This is the first time that private credit is being used as an asset class. However, he also said, the ongoing turmoil "could become the first real test for private credit."
Read the original article on Nikkei Financial.