Private credit is the regulatory fix that became an asset class

Randy Schwimmer

Vice chairman Churchill Asset Management

Institutional investors have pushed private credit to greater scale than either loans or bonds

An excellent state of the market study from Evercore’s private funds group refers to private equity as “the corporate governance fix that became an asset class”. The thesis is that private equity sponsors solve strategic problems for businesses with capital and by aligning management upside with performance. Their support has led to the development of an industry with USD 14 trillion of AUM.

In the same way, private credit has grown from a backwater of middle market lending in the 1980s to beachfront, as the fastest growing element of the capital markets. We would suggest private credit is the regulatory fix that became an asset class.

Post-pandemic private markets survived COVID shutdowns, supply-chain crises, high inflation, high interest rates and persistent threats of recession. At the same time, banks retreated from high-yield credit as liquidity drained from the financial system. Private credit managers, propelled by investor appetite for consistent yields for less-correlated assets, took over buyout financings.

Today the outlook for higher interest rates has softened. While the timing of cuts shifts with each PDI report, BSL activity has accelerated, aided by a widening spread premium relative to direct lending. Will heightened competition among top lenders lead to increasingly aggressive terms and challenged recoveries?

Increasingly, media and research reporting seems stuck in the early 2000s, leading to mistaken pattern recognition. But default and valuation dynamics in public markets arise from a very different context than in private. Large buy-and-hold private credit managers commit to terms that don’t change with daily market moves.

These dynamics have led to a role reversal. Historically, broadly syndicated loans represented the organised, institutionalised, efficient and disciplined market, with the middle market spotty, niche and less well-organised. But the huge influx of institutional investors has pushed private credit to greater scale than either loans or bonds, with leading managers speaking for the largest financings, regardless of cycle, rates or complexity.

Now that liquid loans are back, albeit mostly as refinancings, large issuers have choices. This is not a path to value destruction, but creation. Private credit managers offer a wide range of solutions, including those for borrowers challenged by high interest rates. In some cases, this will be a convenient off-ramp for BSLs.

Still, banks struggle with the new order. While arguing for non-bank regulation, they jump-start their own direct lending businesses or partner with established firms. They are also sticking to less leveraged, amortising term loan A offerings, concentrating on sectors where in-house groups provide an edge. Financials (for example, Truist Insurance), aircraft (Bombardier), travel and leisure (Hilton), energy (NorthRiver Midstream) and commodities (US Silica) are examples where banks have been competitive for decades.

Meanwhile, by providing fund leverage and financing lines to direct lenders, banks enter private credit through the back door. When top private credit managers launched two decades ago, banks got them started. Those relationships were critical to maintaining diversified, long-term liabilities through any business cycle. But today the largest direct lenders are raising significant LP dollars to accommodate multi-billion-dollar debt financings. These buy-side asset managers have mimicked the sell-side investment banks by developing syndication desks to handle oversized commitments and feed external lending partnerships.

Direct lending is different

Educating investors clearly on the changing of the guard from banks to non-banks is essential. Defaults, recoveries, prices, spreads, volatility — all emerge and operate in different ways depending on whether they occur inside or outside a bank-style regulated environment.

Fundamental distinctions will remain. Investment banking will never be asset management, though players may use partnerships and acquisitions to supplement their businesses. And investors will benefit from those differences. The gravitational pull towards private capital means better access to high quality, high-yielding assets less sensitive to headline news. It allows for more diversification of risk among sophisticated institutional investors and away from depositors — and also provides a glimpse of the future bank/non-bank ecosystem.

Increasing competition from loans

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