Private Lending and Today’s Market
September 15, 2023
Read Time: 4 minutes
Private Markets
With dry powder nearing $500 billion for private credit1 and the highest interest rates in 22 years, private credit is, more than ever, primed for new investment opportunities. With tightened lending practices, the Basel III endgame reforms, and an uncertain political environment, private credit has emerged as the 2023 golden child for private markets.
As firms invest in private lending at an increased pace, we’re exploring what’s behind the boom.
First and foremost, there is a demand for credit. Banks have tightened their standards for non-traditional debt and are limiting how much they lend to private and growing institutions. Coupled with the collapse of three regional banks in early 2023, real estate developers, venture, low- to middle-market, and other private firms with non-conventional financing needs now face a funding void. Pre-COVID loans are coming due, and while there may be extensions or add-ons issued at current terms, loans will soon expire and need refinancing. With their rising levels of dry powder, private lending firms, are ripe to step in and service this market.
COVID-19 had a material impact on private credit. Not only are the early and pre-COVID loans maturing, more distressed debt opportunities are expected as firms continue to recover. Considering the current environment, private credit firms are well-positioned to set favorable terms allowing for strong downside protection. Credit continues to generate consistent and predictable income through the life of the loan, along with a set maturity date that can be planned for. Cost of capital has been increasing somewhat rapidly, playing into the excitement of this market.
New deals and exits have been slow in private equity because firms are holding onto investments longer. Waiting for valuation adjustments to settle and rates to top ties up cash that LPs would like to redeploy now. Not later. By investing in credit, firms can determine expected returns and the timeframe for cash to protect against this unknown in the future.
Private credit is typically secured by collateral and default rates have historically been near zero. Defaults are expected to increase a bit as the market comes down the other side of COVID loans. Firms either recover from the economic impact or they don’t. But that won’t change significantly and is another reason why private credit looks to be one of the safer investments.
With floating rates and an established floor for those rates, the upside is protected for these loans. Private credit firms bring rigorous due diligence and flexibility that a bank might not have to approve loans that don’t fit a specific profile. The ability to tailor loan terms, negotiate covenants, and structure the deals to meet the specific needs of the borrower and lender can lead to more favorable terms, lower risk, and dare we say, higher reward.
Year-to-date, debt issued has largely been for existing borrowers, allowing for flexibility and speed in approval and issuance processes. With bank lending, this flexibility would not exist. Borrowers may not have the time to wait through a long process at the risk of losing an opportunity. New clients typically need money immediately and can’t wait out lengthy bank processes only to be told no or not get the complete amount they request.
In explaining the size of the universe, one manager we heard from gave the example of: if 10% of the 4,000 mid-market companies need money within a year, private credit firms have a lot of new opportunities to provide capital. The US markets support issuing debt and recognize this is an underserved market.
With a slowdown in private equity and fluctuating valuations, firms are holding investments longer. This leads to capital lockup and fewer deals. Therefore, private markets firms, their investors, and partners need to find ways to diversify their portfolio to bolster their returns. The diversification is not just moving into private credit, but also diversifying within the portfolio to include direct lending, mezzanine, and bridge or distressed financing, and not just in classic private credit areas, but to newer areas like litigation and royalty financing.
GPs aren’t the only ones increasing funding in private credit to secure consistent and predictable income. LPs, family offices, and insurance companies looking to diversify and reduce exposure to market volatility are also exploring private credit. The mantra is increasingly becoming: diversify, as the rest of the market is expected to lag.
A key benefit is that private debt doesn’t dilute a firm’s ownership unless otherwise agreed as part of the terms. In addition, firms don’t need to report debt to the ratings agencies. In some cases, the due diligence process is less burdensome. Terms also tend to be more flexible and tailored to the specific needs of the firm.
Private credit is mutually beneficial for borrowers and investors. Through risk mitigation strategies, due diligence processes, and collateral protection, investors can navigate the risks, and borrowers can spend time adding value to and growing their business.
Are you ready for the impact of this change on your business and teams? With the growth of potential investment opportunities, the data that firms need to manage and interrogate will only increase. Contact Arcesium to learn how we can help support and facilitate this growth.
Sources:
1. Dry Powder & AUM, Pro Preqin
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