The democratisation of private credit

Direct lending, an attractive asset class, once only available to institutional investors, is growing in popularity among smaller investors

Interest rates remain low while inflation spirals, scaring anyone with savings in the bank. Bull markets don’t last forever, creating stress for any investor seeking to shock-proof their assets. In such a context, few asset classes look quite so attractive as private credit – specifically direct lending – which typically pays a yield premium to its public market alternatives often with much lower volatility.

Direct lending is a strategy whereby a company borrows money directly from a private lender rather than from a bank or the syndicated debt markets. The loan is typically senior-secured, floating rate and charges interest on a quarterly basis. Until recently, however, this was an investment strategy which appeared to be available exclusively to the super-rich. Institutional investors had to commit $10m plus minimums to skilled investment managers via funds where the capital could be locked up for periods of up to a decade.

Now, however, a significant expansion in the market is leading to its democratisation. Smaller investors have the ability to access this strategy with lower minimums and greater liquidity thanks to a structure known as the business development company (BDC) which has grown in popularity markedly over the last 18 months.

In the last two decades, the private credit market has not so much expanded as exploded. According to Preqin, a data and analytics provider on the alternative assets industry, assets under management (AUM) for private credit reached $1.2tn by the end of 2021. For context, in 2000, AUM was $42bn and in 2010, $312bn. By the end of 2025, private credit assets under management are projected to double to $2.4tn and outstrip even real estate debt.

Private lending is as old as money itself but the BDC, as a financial product, was born in 1980, due to legislation passed by the US Congress to help businesses raise money to scale and create jobs in the wake of an economic crisis. Business development companies work by investing money in privately owned companies that need help to grow with the aim of generating income and capital gains; the same strategy employed traditionally by investment managers for institutional investors. Traditionally the BDC’s were listed on a US stock exchange allowing investors liquidity through the purchase and sale of the company’s shares. This, however, also came with the downside of exposing investors to equity market volatility. More recently a ‘non-traded’ variant of the BDC has become increasingly popular whereby investors can access liquidity via the ability to redeem their holding at net asset value, in some instances on a quarterly basis.

The trillion dollars of assets under management in private credit is a relatively recent phenomenon

The BDC market is still small in comparison to the entire industry but growing fast. According to the BDC Council, there are currently 122 in total, with over $180bn investing in small- and medium-sized businesses across the US. Effectively, BDCs are an innovative structure leading to the democratisation of private credit by providing smaller investors access to strategies which were capitalised upon only by institutional entities of high net worth. Tax efficiency adds to their appeal.

HPS Investment Partners is one of the leading credit managers globally, with more than $85bn in assets under its management, and its analysis suggests we are at the tip of the iceberg when it comes to the democratisation of the direct lending market. “The trillion dollars of assets under management in private credit is a relatively recent phenomenon and the democratisation from the realm of institutional capital to the realm of non-institutional investors is even more recent. [There are] two things that lie behind democratisation.” says to Michael Patterson, governing partner and portfolio manager for direct lending at HPS.

He adds: “One, there is a significant level of interest from non-institutional investors for this asset class, given the attractive and consistent yields that have been generated by direct lending relative to other credit instruments. Two, we have only recently started to see innovative structures such as non-traded BDC’s that allow this investor base to access private credit in a cost-effective manner.”

A non-traded BDC, he says, is just one of the instruments “that are being created to allow non-institutional investors to access this strategy at more reasonable minimums, with more stable entry and exit prices while generating regular, stable income.”

When trying to make sense of the current market for private credit it is important to examine the events which led to its creation. In the wake of the 2008 financial crisis, regulatory reforms, designed to prevent the crisis repeating, such as Basel III, sought to strengthen risk management in banks and penalised them for holding non-investment grade debt which was often previously kept on their balance sheet. This created a vacuum which investment firms such as HPS were able to step into and serve as strategic capital partners.

Since then, direct lending has become a mainstream investment strategy which has increased exponentially over the past decade. Furthermore, as specialist credit firms and funds grow in size, the capability to underwrite larger and larger investments is also increasing. Private loans in excess of $1bn are already becoming a common occurrence in the market.

Seismic geopolitical events – including the Covid-19 pandemic, global supply chain issues and the war in Ukraine – explain why 2020-2022 has been such an exceptional time for private debt lenders. Investors who included private credit and direct lending in their investment portfolios experienced significantly less volatility from a pricing perspective, which meant fewer sleepless nights. In fact, volatility proved to be beneficial to firms such as HPS. In times of uncertainty, banks generally don’t want to lend, and the syndicated debt markets shut down which is another factor contributing to excitement over this asset class. That is not likely to dissipate with fears of further shocks to come.

“When you go into periods of heightened risk, as we see right now,” Patterson says, “The bank-led syndicated markets tend to pull back and that often forces larger borrowers towards the private debt market even more than in a normal environment.”

Private credit is more expensive for borrowers because investors want a return on their capital: BDCs provide management expertise to help companies continue to grow, develop and fuel acquisitions. “Basically, on one hand, the regulator is pushing this out of the remit of the banks while, on the other, the market opportunity is attracting capital into this asset class because yields are significantly higher, and performance is more stable than in other asset classes,” Patterson adds.

This year, analysts predict that we are likely to see the first $5bn private senior secured loan, providing yet another indication that the private credit market is on a trajectory to become the second largest private asset class: if democratisation continues at its present pace, it won’t just be institutional investors who benefit.

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Promoted by HPS Investment Partners