What is Private Credit? Definition, Advantages, Risks, Trends to watch (Goldman Sachs Briefings)

An introduction to demystify private credit from GS briefings - Lotfi Karoui (GS Research Chief Credit Strategist) and James Reynolds (GSAM Global Co-head of Private Credit)

What is Private credit and what is direct lending?

It used to be the case that if a business wants to borrow money, the owner usually goes to a bank to get a loan. Note that the bank doesn’t actually hold this loan, it’s syndicated, i.e. sold to the someone else in the wider market to both

a) offload the risk of possible default (in case of a bad debt), and

b) making a profit (sell to the market at a spread on the yield).

Direct lending - put the borrower directly in discussion with the eventual lender, so it offers the ability for companies to borrow without an intermediary (the bank).

The word ‘private’ in private credit simply means it’s end-to-end private market transaction.

Why would companies do direct lending (borrow directly) instead of going through banks?

Benefits include:

1. Banks are not the eventual holder of the debt, so they will consider the state of the market at the time of syndication before lending the money. Therefore, the borrower doesn’t know the price of the debt at the time when financing is underwritten. This is particularly risky at volatile market conditions (e.g. now) as the debt can be a lot more costly than the business would like. Whereas with a direct lender, borrower can negotiate the price upfront.

2. Terms of financing can be bespoke, as it’s up to the lenders and borrowers. The transaction is OTC, and the process is confidential.

3. No need for business management to go to a ratings agency, whereas they would need to if they were to issue a public bond.
   

It’s important for business to know and trust their lenders (owners of their debt), and it’s more difficult to do this with the public credit space over the sheer volume of debt holders, i.e. any retail investor can become the debt holder of a company if you buy their bonds in the market.

What are some trends we're seeing in the private borrowing space?

Borrowers are larger and of higher quality, debt type and size can include unitranche to privately placed financing up to $3-4billion. So there’s a trend that businesses who have no problems borrowing in the public market are purposely going private over the benefits described above.

More on private credit as an asset class

Currently, there are $1.2 trillion in this asset class globally including direct lending (largest constituent at 40%), infra, distressed, special situ etc.

This means that it is now a scalable asset class, comparable to other established markets e.g. HY bond ($1.6tn), or broadly syndicated leveraged loan ($1.4tn).

This is partially due to the fact that Investors want more upside on yields, which can also be achieved in the public credit space (public credit yield especially on HY bonds is rising), but the risk-adjusted performance (higher Sharpe ratio) is the key reason for going private. Note that this outperformance is paid for with the cost of illiquidity.

However, this shouldn't pose an issue as the majority of private market owners are net liquidity providers instead of net liquidity consumers, such as pensions, insurance companies, SWF, Family office etc., who don’t require liquidity. What they really want is the higher Sharpe returns, to deliver higher alpha on the portfolio.

Concerns: How will the private credit space behave in the current macro environment (rising rates, tightening credit)?

From an investor's perspective: rising rates and downward economy has led to bad performance in the public side compared to private side, which means right now the public side looks cheaper than private, so they could choose to invest in public over private, and this can lead to less demand for private so valuation could be slightly down.

But structurally, the higher Sharpe performance continues to exist, so the private credit space will still grow due to structural benefit, perhaps just at a slower growth rate.

From a borrower's pespective: direct lending is usually done in floating rates terms, i.e. the lenders will lend to the borrower at a spread above the current interest rate, so this rate is subject to change as the overall interest rate changes to protect the lenders from interest rate risk. This means that the immediate large front end rate hikes lead to much higher borrowing cost, which could mean that some borrowers might not withstand the pressure to borrow privately, when issuing public bonds that have both fixed rate and an extended average maturity since 2-3 years ago can yield a lower cost of borrowing.

Note: over covid, sponsor backed (PE backed) companies bonds outperformed non-sponsor backed ones as the market thinks the ability to obtain more funding for the portco is an upside, so has offset some headwind for private credit

How are rising costs affecting the private credit investing landscape?

Investors are shifting focus to firms with:

1. Pricing power - able to pass on inflationary pressure to consumers

2. Stable cash flow

—> gravitating to healthcare, and software ERP in europe (low churn, good pricing and can grow volume from new product launch), essential services globally

—> avoid ones exposed to Commods prices (manufacturing related)

Will start seeing higher defaults from higher rates.

More opportunities - reason:

1. Dry power x3 from 15 years ago

2. Banks are retrenching due to volatility as less confident in syndication (senior and junior)

3. More companies who’ve raised capital before need to restructure balance sheet so opens a window

Pace of fund raising in PC

Near term, public markets are resetting from valuation, yield looks attractive

But long term, structural outperformance means this space will continue to grow

Protection for borrower and lenders as is less regulated than public credit?

Stronger protection in fact, higher standards for DD. Usual concern is related to shadow banking and shadow lending, but unlike GFC which had 2 features:

1. leverage - DL has very little leverage used, nothing close to GFC

2. Mismatched balance sheet liability and obligations

Any popular concerns for systemic risk?

Will these asset class produce the same return in this cycle as the previous one?

Pc is increasingly sold to retail investor —> will become more regulated

Large loss on DL portfolio will eventually cause a contraction in credit for borrowers

Low leverage right now, and absolute terms dry power in DL is still small compared to the overall credit complex, and LPs are usually very diversified in their own portfolio, PC is still very early in the growth phase