As traditional lenders have retrenched in the wake of the Global Financial Crisis and, more recently, on the back of a spate of regional bank failures, suppliers of private credit have increasingly filled the vacuum. Today, private credit in its myriad forms is no longer just an intriguing alternative asset class, but arguably a foundational pillar of the financial system—offering what we consider attractive opportunities for investors.

A Vast Menu of Credit

In 1899, the American Telephone and Telegraph Company issued what may have been the first “private placement memorandum,” and the modern private credit market was born. But private placements were just the beginning. Today, a vast menu of private credit arrangements now finances nearly every aspect of the economy, with a market that has expanded from $230 billion in the wake of the 2008 Global Financial Crisis to north of $2 trillion today (see display).

Private Credit Has Seen Explosive Growth Across the Economy

Global Private Lending, Assets Under Management

 

Source: Preqin, Goldman Sachs Global Investment Research, as of December 31, 2023.

Traditionally, much of the private credit market has consisted of corporate lending, which mainly focuses on financing acquisitions led by private equity managers. But with stunning growth has come increased specialization beyond corporate lending, including various forms of asset-backed and “opportunistic” financing. Asset-backed lending includes consumer credit, commercial and residential mortgages, equipment leasing, project finance and fund finance; opportunistic lending covers all other niche segments, from insurance-linked securities to litigation funding. Taken together, the total market for private credit could reach $5.4 trillion by 2027.¹ In particular, we think the large U.S. middle market could yield attractive opportunities for selective private credit providers.

Midsized Companies Represent a Major Opportunity

GDP by Country, Middle-Market Revenues

 

Source: National Center of the Middle Market, “Middle Market Update,” August 9, 2023; The World Bank, 2022. Middle-market companies are defined as those with between $10 million and $1 billion in revenue.

Evolving Regulation

Private credit has been a major beneficiary of bank regulation since the Global Financial Crisis, and we believe it will likely continue to experience significant growth in the wake of “Basel III Endgame,” a regulatory standard that will be phased in over the next few years. If implemented as proposed, Basel III Endgame would compel large U.S. banks to increase common equity capital requirements against so-called risk-weighted assets (RWAs) by upwards of 20%.² While we think the final rule will likely be softened, its ultimate impact could still be material—and indeed many banks have since gone on “RWA diets” that reduce their exposure to certain loans and sectors, while some have partnered with private capital providers to offload non-investment grade risk.

Redrawing the Financial Map

Amid the tightening regulatory regime, traditional bank lenders and private credit providers are forging a productive symbiotic relationship. At the same time, some observers worry about perceived opacity and light regulation of private credit markets. While it appears that some areas of the market may face stiffer competition, however, we believe that, on the whole, selective private capital providers are maintaining reasonable levels of risk, but are also helping to bolster the overall stability of the financial system.

First, unlike most banks, which rely on funding from deposits (which can be short-term in nature), most private credit strategies are “match-funded,” meaning that their assets and liabilities have similar maturity profiles. We believe this reduced asset-liability mismatch makes private capital providers logical holders of longer-term assets.

Second, in our experience, private credit funds often take on less balance sheet risk by employing either modest leverage—up to one times equity capital or none at all, compared to the typical 10 times for traditional banks.

Third, we believe private credit arrangements can be more transparent than critics suggest. Take Business Development Companies (BDCs), a roughly $300 billion sector that invests primarily in direct loans.³ As regulated investment companies, BDCs must disclose, via quarterly public filings, not just the composition of their portfolios, but also their valuation methods and investment performance. Although banks must adhere to rules set by the Federal Reserve and other regulators, their disclosures tend to address the broader health and credit quality of their balance sheets rather than specific details on individual loans.

Is a Bubble Brewing?

As the market for private credit expands, some investors wonder whether a bubble has begun to inflate. However, while we’ve seen a crop of new entrants, we believe this is more indicative of shifts in market share than evidence of a bubble.

Consider, to start, the pronounced supply-demand imbalance between private equity sponsors and private credit providers. The amount of unallocated private equity capital is nearly twice that of private debt.⁴ We believe this disparity underscores not only the unmet demand for debt financing, but also the ability of private credit markets to absorb additional inflows without unsustainably inflating asset prices.

Next, we think demand for credit could remain strong well into this year—especially within the middle market, which often relies on private credit—and could continue to offer fertile ground for prudent lending. To illustrate, the National Center for the Middle Market estimates that 65% of midsize companies expect year-over-year revenue growth—and about 60% expect to expand their workforces—through the second quarter of 2024.⁵ Private equity-backed middle market firms, in particular, continue to post strong performance. During the first two months of 1Q 2024 (the latest data available), earnings within this segment grew by 11% year-over-year, while revenues increased 5%. The technology sector continued to be a standout performer, with earnings and revenue growth of 26% and 8%, respectively.⁶

Importantly, loan losses in the middle market are low on a historical basis, and have remained below thresholds observed during the COVID-19 pandemic.⁷ We believe that challenging period provided a meaningful (albeit brief) stress test, revealing private credit’s potential durability in the face of unprecedented economic volatility. Rising/elevated interest rates over the last 18 months have further tested that resilience, yet strong performance has generally persisted in the market. Meanwhile, private equity sponsors have played a pivotal role in bolstering the financial stability of their portfolio companies. By injecting additional equity, they have enhanced liquidity and provided a cushion against downturns.

In our view, sponsors’ proactive approach is a testament to the strengthening relationship between private equity and private credit, wherein both parties have a vested interest in the success and solvency of their investments.

Conclusion: Building Momentum

Looking ahead, we expect the burgeoning market for private credit to continue to expand and evolve, driven by shifting regulation, deepening partnerships with traditional lenders, and continued potential for attractive risk-adjusted returns. The remarkable rise of private credit reflects its important long-term role across an ever-changing financial landscape, and reinforces its potential benefits to investors.