Private Credit - Part II

Part I appeared earlier this week. The full article can be found here. If you would like to read more about business transformation, restructuring, turnaround and value creation from a middle market perspective, visit and subscribe to Base of the Pyramid.

Structural Characteristics of Private Credit

In order to understand the new and still-evolving paradigm that we have entered with private credit, it is useful to examine the structural characteristics as manifest in market transactions. The data indicates that private credit is experiencing some growing pains, though overall the story seems to be one of an asset class that continues to operate with the benefit of market tailwinds.

• Dry Powder. The incredible growth of private credit assets under management has already been commented on (see Exhibit A). However, as the asset class has continued to attract capital it is noteworthy that dry powder, or committed but uninvested capital, is large both as a nominal value and as a % of total AUM (see Exhibit D).

Exhibit D: Private Credit AUM Breakdown

• Concentration. As an asset class, private credit is showing considerable concentration, with analysts estimating that the top 10 U.S. private credit managers hold up to 45 percent of the total dry powder of the asset class.
• Origination. Loan origination has been robust and upward sloping (see Exhibit E), and average loan size has nearly doubled (up 83.7%) from 2013 to 2023 (see Exhibit F). 

 Exhibit E: Private Credit Loan Origination

Exhibit F: Private Credit Average Loan Size

• Loan Type. Various types of term loans dominate, with revolvers accounting for only 9% of private credit loans (see Exhibit G).  

Exhibit G: Private Credit Loan Types

• Maturity. Private Credit does not appear to have a maturity wall problem, with a maximum of 21.4% of loans coming due in any year through 2032. Additionally, the average term for private credit loans had hovered in a tight band from 2013 – 2022, averaging just over 5 years, before falling to 4.4 years in 2023 (see Exhibit H).

 Exhibit H: Private Credit Loan Maturity

• Deal Types. Unsurprisingly, the majority of private credit deals by dollar volume are associated with either M&A activity or debt refinancing (see Exhibit I).

 Exhibit I: Private Credit Deal Types

• Loan Spreads. In aggregate, both private credit loan spreads over benchmark rate and the private credit loan premium when compared to leveraged loans, have declined since 2013 (see Exhibit J). 

 Exhibit J: Private Credit Loan Spreads

• Interest Coverage Ratio. Between Q1-21 and Q3-23, the interest coverage ratio for private credit loans declined by over 35% (see Exhibit K).

 Exhibit K: Private Credit Loan Interest Coverage Ratio

Benefits of Private Credit

The growth of private credit as an asset class is a testament to the fact that it has met and continues to meet the needs of both investors and debtors in fundamental ways.

Investor Benefits:

• Risk Premia. Since the GFC, investors have been pushed by interest rate policy (and some by regulation as well) to seek out risk premia wherever they could be found, and private credit offers just that. The challenge here is how stable these premia are, and to what extent they are driven by non-cash PIK interest which may obscure debtor challenges meeting their cash debt service costs. When examining the data, it appears that competition is driving down the private credit risk premium (see Exhibit J), which raises the question of what premium represents adequate investor compensation for the (current) illiquidity of the asset class. 
• Hold Periods. Private credit loans are typically held to maturity, and this feature is presented to institutional investors as a significant benefit in that it avoids the need to mark to market loans when debtors experience temporary downturns. The challenge here is twofold: 1) not all debtor problems are temporary, and a reluctance to mark down loans can obscure the true value of troubled loans and potentially mislead investors, and 2) this feature, arising as it does from regulatory arbitrage, is not certain to be permanent, and given the plans of several market participants to launch private credit trading desks it may be increasingly difficult for private credit managers to justify even in the absence of formal regulatory changes. 

 Debtor Benefits:

• Bespoke Structures. The existence of a large and growing class of capital providers eager to craft bespoke financing solutions for suitable companies may seem like a godsend to leadership teams and advisors, and in many ways this market change is a clear net positive. However, these bespoke structures entail a heightened level of complexity in financing with which some companies will struggle.
• Streamlined Lender Negotiations. Private credit managers often maintain that, due to their model of holding loans to maturity, as well as their funding structure (see Exhibit L), they are better able to accommodate debtors facing challenges. In terms of simplifying coordination, a private credit dominated market would seem to offer some advantages, by virtue of there being fewer creditors with a troubled debtor must negotiate. However, the relative level of tension in forbearance or restructuring discussions relies upon not only the number of parties to the discussion but also the ability of those parties to come to terms, and there is nothing structural in private credit that will inoculate this group of lenders from contentious disagreements on the either the need for or the nature and terms of lender relief.

The benefits of private credit for both investors and debtors are compelling, and the value proposition has been validated by the market. However, there are unresolved questions surrounding each of the above perceived benefits.

Exhibit L: Private Credit Fund Structure

Private Credit Impact on Restructuring

Elias and de Fontenay note that a market dominated by private credit represents not only a shifting of market share from one class of lender to another, but a structural increase in credit available to the companies these lenders serve, due to private credit lenders underwriting to enterprise value as opposed to the more conservative approach of banks, which tend to underwrite to liquidation value. It is tautological to note that higher levels of aggregate debt will lead to higher levels of distress, ceteris paribus. We can therefore reasonably assume that the need for restructuring will increase as private credit extends its influence and the full impact of an aggregate increase in leverage makes itself felt throughout the market.

A logical follow-up to this conclusion might be to ask what form restructuring activity might take in a private credit dominated market. In answer to this I quote at length from Elias and de Fontenay:

First, to the extent that private credit increases the size of the corporate-debt pie (by providing leverage to new borrowers and adding more leverage to existing borrowers), the rise of private credit should produce more episodes of corporate financial distress and insolvency. Second, however, among firms that are financially distressed, private credit should lead to fewer bankruptcies.  The structure of private credit deals – with fewer lenders at the bargaining table – could solve some of the coordination problems and creditor conflicts that plague workout talks for large firms and require the bankruptcy process for resolution.  In addition, some private credit lenders are more willing than traditional banks to take over ownership of distressed firms or their assets. To the extent that private credit replaces traditional banks for smaller loans to middle market borrowers, therefore, it may offer a new bargaining counterparty that is better able to restructure deals, own assets and inject new capital when necessary.  Third, and counterintuitively, for some subset of corporate borrowers, private credit may delay resolution of the firm’s financial distress inefficiently. As discussed above, in most cases private credit should result in faster renegotiation and restructuring than public and quasi-public debt, by reducing collective action costs.  Unlike investors in public and quasi-public debt, however, private credit lenders sometimes have both the incentive and the ability to avoid taking or marking losses on their loan portfolio, and to forbear instead indefinitely in the hope that the borrower’s condition improves. Such incentives raise the risk of so-called “zombie firms” among private-credit borrowers. At this stage, we do not know enough to gauge the severity of this risk.

More distress, and hence more restructuring, but fewer bankruptcies, and an increase in zombie firms. Market innovations do not come absent negative externalities.

Lower Middle Market Implications

For companies in the lower middle market, a finance ecosystem dominated by private credit lenders will present several difficulties that must be carefully navigated:

1. Heightened Complexity. Over a career spent predominantly in the middle market, I can say confidently that the talent challenge these companies face is not an absence of top-tier talent so much as it is a lack of bench depth. Many small and medium-sized companies have talented and supremely qualified individuals within their ranks, but the drop-off in quality from these stars to the modal employee in some firms can be substantial. Private credit, with an ability to structure bespoke financing solutions, will place significant demands on the leadership and advisory teams of lower middle market companies. Some companies will rise to the challenge of these demands, but some will inevitably falter.

2. Predatory Lenders. As a philosophical matter, it is interesting to ponder what unforeseen developments will arise from a situation in which the modal incremental lender is willing and able, in some cases even eager, to assume ownership of a troubled creditor. Family-owned companies could be in for a shock when a request for loan forbearance becomes a discussion of a restructuring that will transfer ownership to the former lender. 

3. Disappearing Revolvers. Revolving lines of credit are the workhorse financing facility for small and midsized companies. These credit facilities allow companies to address short-term and seasonal cash flow weaknesses while also serving as a low-cost means of increasing leverage given that debt service is typically interest only with the loan balance due upon maturity. In a world dominated by private credit, given the observed preference of private credit lenders for term facilities over revolving lines of credit, it is easy to imagine some companies facing higher than anticipated debt service costs not only due to the premiums private credit commands, but also due to the structure of loans that the asset class favors.

4. Increased Competition. Many small and midsized businesses are content to operate in profitable niches and cede the broader market to their larger brethren. However, increased capital availability will create powerful incentives for companies willing and able to utilize private credit to invade these formerly safe niches and dominate them, either through acquisition, competition, or some combination of the two. Unfortunately, some increased competition will likely come in the form of zombie companies who, due to the incentive structure of their private credit managers, are permitted to continue operating absent a comprehensive restructuring, reducing overall sector profitability in the process.

The bottom line for lower middle market companies and their leadership teams when considering the implications of private credit is that things will be trending in the direction of greater complexity, long-established relationships becoming adversarial, mismatches between offered vs. desired loan structures and heightened competition.

Conclusion

The rise of private credit represents a new lending paradigm, but new paradigms are never universally positive. It is somewhat disquieting to reflect that an asset class which has experienced such tremendous growth remains untested through a traditional economic cycle, and it remains to be seen whether the claimed benefits of private credit are truly structural and enduring, or if they will prove in the fullness of time to have been more evanescent than originally thought. Private credit has profound implications for restructuring, suggesting a heightened level of out-of-court restructuring activity but perhaps a lower volume of bankruptcy filings. And from the standpoint of lower middle market companies in particular, private credit suggests a more complex and contentious world that must be carefully navigated by leadership and advisory teams.    

About the Author

David Johnson is the founder and managing partner of Abraxas Group, a boutique advisory firm focused on providing leadership and support services to companies in need of transformational change. He is an accomplished thought leader with multiple articles and speaking engagements on the topics of business transformation, change management, performance improvement, restructuring, turnaround, and value creation to his credit. David can be reached at: david@abraxasgp.com.

Part I appeared earlier this week. The full article can be found here. If you would like to read more about business transformation, restructuring, turnaround and value creation from a middle market perspective, visit and subscribe to Base of the Pyramid.