The Rise of Private Credit and What Lies Ahead

The exponential growth of the private credit market has become a constant headline in Wall Street news, positioning it as the “buzziest corner” on the financial street. With assets under management soaring to approximately $1.6 trillion and forecasts showing a trajectory of continued growth, private credit has undoubtedly caught the attention of global investors.

What is Private Credit?

Fundamentally distinct from traditional banking, private credit operates on a unique model. While banks transform short-term deposits into long-term loans, private credit firms raise capital directly from investors, funneling funds to corporate borrowers without bank intermediation. The private credit market includes sectors like direct lending, mezzanine financing, distressed debt, and structured credit, with direct lending being the most prominent. In essence, direct lending involves companies borrowing from non-bank lenders—such as private equity firms—who retain these loans until maturity in their portfolios.

Although the activity of non-bank entities in providing private credit is not new, the boom in the direct lending market is a result of the higher scrutiny imposed on banks after the 2008 financial crisis. Regulatory reforms implemented in the aftermath imposed stricter requirements on banks. With increased regulatory scrutiny and a decline in banking activity, a lending gap emerged where non-banks thrived providing credit, especially to small and mid-size businesses.

Additionally, as a measure to constrain the impacts of the 2008 crisis, the Federal Reserve implemented a zero-interest rate policy ("ZIRP") to stimulate household spending and increase investment by making borrowing funds even cheaper. So, the market dynamics shifted as investors sought higher returns amidst a low-yield environment, prompting them to explore alternative avenues such as private credit.

More recently, both the ZIRP policy during the COVID-19 pandemic and the collapse of regional banks in the American market in 2023 accelerated the movement of borrowers from the traditional lending market to the private credit market. For investors, private credit, with its promise of attractive risk-adjusted returns and diversification benefits, once again appeared as a favored asset class.

This prompts us to question: what factors have contributed to the heightened interest and confidence surrounding private credit as both an investment avenue and an alternative funding source?

Why Is Private Credit Appealing to Borrowers?

From a borrower’s standpoint, direct lending has emerged as a significant alternative funding option, offering terms, repayment schedules or eligibility criteria that tend to be more flexible than traditional bank-intermediated loans. Furthermore, not only does it provide a solution for companies that may be overlooked by traditional banks, it also cultivates a highly advantageous relationship component, where lenders can provide loans more quickly and with pricing often set up front.

The relationship-focused approach, combined with private credit funds retaining loans in their portfolios, provides substantial downside protection. Lenders become more deeply engaged in the company’s success through direct relationships with borrowers. Emphasizing relationship-driven lending underscores the importance of flexibility and certainty in loan execution, especially during economic volatility—factors that may not be as apparent when dealing with a syndicated group of lenders.

Why Invest in Private Credit?

For private credit firms, the floating-rate nature of private credit is a significant aspect as it helps mitigate the impact of interest rate fluctuations, especially in environments where interest rates are anticipated to rise.

The investments typically remain held within firms’ portfolios until maturity. In return for holding “illiquid” assets, investors receive a higher return to offset risk, while borrowers pay a premium for execution certainty, flexibility, and tailored solutions. Consequently, this asset class has been perceived as a complement to traditional fixed-income strategies, offering incremental income and a yield spread above public corporate bonds that compensate for the illiquidity aspect. Over the past decade, private credit has consistently outperformed public high-yield and broadly syndicated loans by three to six percent.

Also, private credit investments often demonstrate a lower correlation with public markets in comparison to asset classes like equities and bonds. This dynamic serves to decrease portfolio volatility and enhance risk-adjusted returns.

Finally, engaging in private credit deals facilitates portfolio diversification while providing exposure to a broader array of companies than those accessible in public markets.

Risk Management and Regulatory Perspective

Nonetheless, with rapid market expansion often come concerns (frequently driven by past experiences), which may lead to increased regulatory scrutiny over time. While the market is not without risks, some structural peculiarities differentiate it from the traditional banking market, justifying low regulatory intervention.

Private credit funds typically maintain low levels of leverage and have limited exposure to derivatives. Additionally, they often secure funding from large institutional investors such as pension funds, insurance companies, or high net worth individuals who lock up their capital for extended periods, ranging from five to ten years. This commitment helps mitigate the risk of a bank run. Unlike bank depositors, investors in private credit funds face restrictions on accessing their capital. As a result, the private credit market is less likely to face immediate liquidity pressures during periods of financial stress, thereby lowering the risk of collapse.

In May 2023, a Federal Reserve report emphasized the minimal risk of financial instability associated with private credit funds. Considering the nuanced aspects of the private credit market, there isn’t an apparent systemic risk comparable to that seen in 2008 that justifies imposing restrictions or subjecting this activity to higher regulatory scrutiny.

Still, there are criticisms regarding the lack of transparency in the market, which indeed can make it challenging to predict default risk in private credit portfolios. Based on a report from Bank of America, a five percent default rate is projected in that market, particularly if interest rates persist at elevated levels for an extended period. Additionally, portfolios are anticipated to witness approximately one third of deals maturing within the next two-and-a-half years.

Firms must diligently monitor asset liability management, especially considering that many companies that have benefited from direct lending in recent years structured their capital arrangements when interest rates were close to zero. However, even in a default scenario, risks typically remain constrained, and the potential for a cascading effect hinges on the interconnection between private credit funds and other market participants.

What Comes Next?

The private credit market’s ability to fill the gap created by retracting bank activity and offer flexible financing solutions to a diverse array of borrowers has contributed to its increasing popularity. As observed thus far, a combination of these factors, coupled with low interest rates and higher returns for investors has been pivotal in the evolution of this market.

As interest rates rise, it naturally puts pressure on companies who financed their businesses when interest rates were low. Some companies are better equipped to handle these challenges than others. For investors, however, the impact ultimately depends on the composition of private credit firms’ portfolios in terms of industry and quality.

Also, the private credit market may face competition ahead, as large banks try to win back market share, especially by offering refinancing deals for borrowers.

While a bumpy road may lie ahead, it seems unlikely that the private credit market will retract. We will certainly continue to navigate the “golden era” of private credit and may very likely see it growing even more in the future.

Laura Ceitlin is a Corporation LLM candidate at NYU, where she serves as a Graduate Editor of the NYU Journal of Law & Business and as the Brazilian Legal Society’s Alumni Relations Officer. Laura is a licensed attorney in Brazil and, prior to attending NYU, worked at a top-tier law firm in Brazil specializing in Corporate Law, Financial Transactions, and Banking Regulation.