Banking Challenges Propel Private Credit Boom: A $2 Trillion Market Shift

The private credit market is experiencing an unprecedented surge as traditional banks grapple with regulatory burdens and market challenges. With large banks constrained by stringent regulations and higher reserve requirements, private credit has emerged as a flexible and efficient alternative for corporate financing. The market has grown approximately 50% over the past three years, reaching nearly $2 trillion in assets under management.¹ This significant shift is reshaping how companies access capital and how investors allocate their resources.

Regulatory Pressures on Banks

In the aftermath of the 2008 financial crisis, banks have faced increased regulatory scrutiny, leading to more cautious lending practices. Capital requirements, stricter loan terms, and enhanced disclosure obligations have made it challenging for banks to extend credit, particularly to high-growth sectors like technology.² The failures of Silicon Valley Bank and First Republic have further exacerbated the cautious stance of regional banks.¹

Private Credit Filling the Void

Private credit funds, operating outside the heavily regulated banking system, have stepped in to meet the growing demand for flexible financing solutions. These funds offer tailored lending options, often with quicker execution and more accommodating terms than traditional banks can provide. The private credit market has grown by $400 billion over the past three years, effectively offsetting the decline in public high-yield debt over the same period.¹

Ashwin Krishnan, co-head of North America Private Credit at Morgan Stanley, highlighted the trend: “Private credit has filled a lending void since the global financial crisis of 2008 and the resulting stiff rules imposed on banks.”² He predicts the market will soar to $2.8 trillion by 2028, an 87% increase from current levels.¹

Variety in Lending Approaches

Private credit encompasses a range of lending strategies, including:

• Direct Lending: Companies borrow directly from non-bank lenders, which typically hold the loans to maturity.²

• Distressed Debt: Funds acquire corporate debt trading below its original value, aiming for profit as the business restructures.²

• Venture Debt: Financing provided to startups that have yet to achieve profitability.²

• Mezzanine Finance: Higher-risk debt that sits between senior loans and equity in repayment priority.²

• Special Situations: Loans extended to capitalize on specific events or circumstances.²

Attractive Returns for Investors

Investors are drawn to private credit for its relatively high yields. Direct lenders can charge between 100 and 300 basis points more than banks syndicating debt for similar companies.² The vast majority of private credit loans have floating rates, leading to increased yields as central banks raised interest rates.²

BlackRock Inc. forecasts the private credit market will double to $3.5 trillion by 2028, citing "tectonic shifts" in financial markets prompting more borrowers to seek out private funds.¹

Banks' Response and Emerging Collaborations

Facing competition from private credit funds, some banks are re-entering the market with more aggressive terms. They offer cheaper deals and fewer covenants to attract borrowers. Additionally, banks like JPMorgan Chase & Co. and Societe Generale SA are creating their own private credit funds or advising clients on these investments.²

Strategic Partnerships

Notably, Citigroup Inc. announced a $25 billion private credit direct lending program in collaboration with Apollo Global Management.¹ This partnership aims to leverage Citi's extensive banking client network and Apollo's deep capital resources, enhancing access to private lending capital at an unprecedented scale.

Steve Boyko, Co-Chair of Proskauer Rose's Corporate Department, commented on such collaborations: “The banks are getting more and more regulated... They don't want to cede their position to the direct lenders. These two partners are being pushed together between the regulatory landscape and the increased need for fundraising.”¹

Risks and Regulatory Considerations

While private credit offers attractive returns, it comes with risks. The lack of liquidity compared to public markets can lead to steep losses if investors need a quick exit. Some funds lock in capital for more than five years without formal trading mechanisms. ² Additionally, private credit funds have fewer obligations regarding disclosure, making it difficult to assess the true value and risks of investments.³

Potential for Increased Defaults

The surge in yields due to rising interest rates could strain borrowers, increasing the risk of defaults.² Colm Kelleher, UBS Group AG Chairman, warned of a dangerous bubble in private credit, noting that “some private lenders are in a state of denial after the run-up in interest rates.”²

Regulatory Scrutiny

Regulators are paying attention to the rapid growth of private credit. Efforts are underway in the United States and Europe to tighten oversight, including potential caps on leverage and requirements for greater risk diversification. ² The European Union is implementing guardrails such as leverage caps and diversification obligations for private credit funds.²

Why Investors Should Pay Attention

• Diversify Portfolios: Incorporating private credit can enhance portfolio diversification and potentially improve risk-adjusted returns.

• Stay Ahead of Market Trends: Understanding strategic alliances and market shifts can inform investment decisions and help capitalize on emerging opportunities.

• Attractive Returns: The asset class offers yields on par with private equity but often with less risk.²

Assessing Risks

• Liquidity Considerations: Be mindful of the illiquid nature of private credit investments and the potential challenges in exiting positions.

• Due Diligence: Conduct thorough analysis of credit risk inherent in private lending when considering investments.

• Regulatory Changes: Stay informed about evolving regulatory landscapes that may impact the private credit market.

Conclusion

The explosion of private credit amid struggling large banks represents a significant milestone in the evolution of corporate financing and investment opportunities. As private credit continues to ascend into mainstream finance, investors have the chance to capitalize on emerging opportunities. However, they must also navigate the associated risks carefully. Collaborations between banks and private credit managers signal a new era of strategic partnerships, potentially reshaping the financial industry's approach to lending and investment.

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_{1. Forbes, Giant Banks Struggle, But Private Credit Is Soaring, 2024.}

_{2. BNN Bloomberg, Why Private Credit Is Booming and Banks Are Fighting Back, 2024.}

_{3. McKinsey, The next era of private credit, 2024}

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