U.S. Private Credit: What the Markets Are Missing About Attractive Risk-Reward Tradeoff

EXHIBIT 1: PRIVATE CREDIT HAS GROWN AT A RAPID CLIP

Source: Bloomberg, as of November 30, 2023

Plenty of Room for Supply to Grow

Disintermediation of bank lending is a long-term trend boosting the supply of private credit. Banks are cutting back on their lending. Their cutbacks aren’t just a function of the economic cycle, which does contribute modestly. Three factors are driving the structural shift in lending:

• Stricter capital requirements make lending less attractive for banks, which find fee-oriented businesses — such as wealth management and asset management — more attractive.
• Banks are receiving fewer deposits as customers migrate to money market funds paying higher rates. This means they have less funds available to make loans.
• Borrowers appreciate the greater flexibility of private credit, which can offer flexible terms, faster loans and less regulation.

EXHIBIT 2: PRIVATE CREDIT ACCOUNTS FOR A SMALL PERCENTAGE OF BANK LOANS OUTSTANDING

Private credit has grown from only 1% of bank loans outstanding in 2000 to 15% of the total in 2023. There’s plenty of room for supply to grow.

Source: Bloomberg, Barclays Research. Data from January 2000 through November 2023.

Opportunities and Risks

In terms of which capitalization of lenders to favor within private credit, Manioudakis finds small- and mid-cap borrowers appear particularly attractive. That’s because banks’ continued lending will tend to favor large-cap companies with which they have global relationships.

As for sectors, Northern Trust Asset Management emphasizes technology, healthcare and industrials because those are the focus of the private equity firms that are many of the borrowers in the firm’s sponsor-backed private credit vehicles. However, it is attractive to also diversify across industries.

Of course, risks accompany opportunities. Due to a lack of robust historical data for this relatively new asset class, it’s hard to say how private credit might respond to a credit crunch. However, private credit default rates have been low — like the rates for other fixed income in this environment of low rates and ample liquidity.

Northern Trust Asset Management seeks to manage default risk by favoring private equity sponsor-backed loans. The advantage of working with a private equity sponsor is that the sponsors have strong incentives to make sure the loans get paid off to preserve their equity. Moreover, within these funds, it’s attractive to focus on first lien, senior secured debt in the specific companies in which the private equity firm has invested. That puts the fund at the very top of that capital stack, which provides a high probability of repayment, shorter maturities because these loans tend to recycle quickly and usually collateral from the specific underlying company that backs up loans, which makes for a higher recovery value in the event of default.

Speaking of default, there is a positive U.S. economic environment that supports low default rates. Among other things, the U.S. economy remains much stronger than those of other developed nations — including the eurozone and the U.K. — due to continued federal government spending, immigration’s contribution to economic growth and easing wage inflation in service industries and relative ease of borrowing, as reflected in financial conditions indexes.

Of course, this could change if there were a crisis on the scale of the Global Financial Crisis of 2008. All lending would be affected.

Manager Selection to Mitigate Risk

To manage risk, investors could select managers carefully, which includes seeking managers that are skilled at fundamental analysis and have long-term relationships with the sponsors with whom they invest.

Most private credit funds are leveraged 0-3x at the fund level. Investors should examine those ratios to determine the extent to which high returns are due to leverage ratios instead of manager skill.

Opinions and forecasts discussed are those of the author, do not necessarily reflect the views of Northern Trust, and are subject to change without notice.

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