A Favorable Climate for Private Credit
Jun 17, 2024
PGIM Private Credit’s Matthew Harvey shares his perspective on private credit and why private credit is attractive for long-term investors.
While the current market environment and slowing economy present unique challenges, private credit continues to offer investors a compelling way to help pursue strong return potential. PGIM Private Capital’s Head of Direct Lending, Matthew Harvey, shares his perspective on the asset class and why he believes his team’s conservative approach can help investors capitalize on the opportunities while potentially limiting downside risks.
HIGHLIGHTS OF TOPICS ADDRESSED IN Q&A
Private credit is debt that is privately negotiated with an issuer, which means it does not trade publicly and is typically not rated by a rating agency. These loans typically offer more leverage than debt issued in public markets and therefore investors gain higher return potential. Private credit loans also offer many structural benefits, such as call protections and covenants, to help mitigate downside risks.
Direct lending is the leveraged loan asset class within private credit and is one of the largest segments of this market. Generally, it consists of floating rate loans to middle-market companies. Since they are directly negotiated with the issuer, these loans are not part of a syndication or broader capital markets transaction and tend to be more illiquid. The loans are typically not subject to traditional capital market dynamics and tend to benefit from less volatility, which can give investors a smoother ride.
Substantial disruption in traditional corporate capital-raising vehicles in recent years has boosted the appeal of private credit. Strong demand in a supply-constrained market since the Global Financial Crisis (GFC) in 2007-08 has helped private credit balloon to a $1.5 trillion asset class-comparable to public leveraged loans and high yield bond markets-and is estimated to expand even more to $2.8 trillion by 2028.
Banks were once the primary source of capital for most companies. However, the impact of the GFC and the advent of enhanced rules and regulatory requirements (e.g., Dodd-Frank Wall Street Reform and Consumer Protection Act) lessened banks’ ability and willingness to issue loans to small and midsize companies. This trend led to rapid growth in private credit, and today non-bank lending makes up 73% of global leveraged loan volume.
After the GFC, central banks worldwide adopted ultra-accommodative interest rate policies, creating strong demand for capital. Because middle-market companies typically don’t have the broad capital market lending options available to larger companies, many turned to private credit for financing.
More recently, rising interest rates and economic uncertainty have pressured bank margins, forcing many to further reduce their mid-market lending activity. After the regional banking crisis in early 2023, we expect further tightening from banks, making it increasingly difficult for middle-market borrowers to obtain traditional financing. It’s even difficult for healthy middle-market companies with strong credit profiles, enhancing the attractiveness of private credit. Private lenders have a longer-term, more asset-driven approach to underwriting risk, so their relative market share versus non-bank investors will likely increase over time.
Private credit is attractive for long-term investors due to consistently strong returns, attractive income hedged against rising rates and inflation, and better diversification.
Private credit has demonstrated consistently strong performance over time and market cycles on an absolute basis and also compared with traditional assets, such as leveraged loans, high yield bonds, U.S. aggregate bonds, and a 60/40 portfolio. While private credit shares some characteristics with leveraged loans and high yield public fixed income markets, it may offer more attractive income potential and provide some structural benefits that can complement traditional fixed income allocations. For instance, the floating rate terms of private credit may provide an inflation hedge in the underlying income profile, distinguishing it from public fixed income markets. Additionally, the loans tend to be largely senior secured with call protections and covenants.
Private credit tends to have low correlation to traditional assets, helping diversify traditional stock and bond allocations in investors’ portfolios. Private credit also is a more fundamentally illiquid asset class than its public market cohort (e.g., leveraged loans and high yield bonds), which makes it less volatile. This characteristic benefits investors when markets sell off and default rates rise. While public investors often need to sell assets in this environment, private lenders can negotiate deals privately with their issuers to better serve investors over the long term.
We think the outlook for private credit is strong. It is a structurally growing asset class for three main reasons: (1) banks ceding their intermediary role, or bank “disintermediation” to non-banks, (2) further disintermediation of non-banks from institutional public markets to private credit, and (3) improving issuer access and education as we move along the adoption curve, with issuers becoming more comfortable with private credit.
The majority of private credit lending funds M&A/LBO related activity, which is cyclical with interest rates. In the short term, overall issuance may be challenged until there is central bank and credit cycle stability. But there is a high amount of private equity dry powder waiting to be deployed. While some private equity transactions will continue to be funded through broadly syndicated loans, borrowers are increasingly seeking financing from private credit lenders. As such, we expect issuance to improve as M&A activity improves.
Longer term, even absent much heightened M&A activity, we expect private credit growth to continue as the shift to non-sponsored lending increases its market share. While borrowers may pay higher upfront costs, they often are more confident that the deal will get done when it is a directly negotiated loan rather than a loan from a large bank. This is critical when financing is needed to meet a stated end goal in a limited time frame, such as a leveraged buyout or funding a business expansion.
Because private credit is generally more illiquid, it is less vulnerable to public market dynamics. When banking or capital markets experience volatility, companies often look to the stability of capital solutions and capital providers, such as private lenders, who can take a longer-term view. As the economy softens and traditional bank lending activity weakens, we believe borrower migration to private credit will grow.
Bloomberg High Yield Corporate Index (High Yield), Bloomberg U.S. Aggregate Bond Index (U.S. Agg), Bloomberg U.S. Corporate Bond Index (IG Corp), Morningstar LSTA U.S. Leveraged Loan Index (Lev Loan), Cliffwater Direct Lending Index (Private Credit). Investors cannot invest directly in an index. Past performance does not guarantee future results.
Cliffwater Direct Lending Index (“CDLI”) seeks to measure the unlevered, gross of fees performance of U.S. middle market corporate loans, as represented by the underlying assets of Business Development Companies (“BDCs”), including both exchange-traded and unlisted BDCs, subject to certain Eligibility Criteria. The CDLI is an asset-weighted index that is calculated on a quarterly basis using financial statements and other information contained in the U.S. Securities and Exchange Commission (“SEC”) filings of all eligible BDCs. Bloomberg High Yield Corporate Index measures the performance of USD-denominated, non-investment grade, fixedrate, taxable corporate bonds, including corporate bonds, fixed-rate bullet, putable, and callable bonds, SEC Rule 144A securities, Original issue zeroes, Pay-in-kind (PIK) bonds, Fixed-rate and fixedto-floating capital securities. Bloomberg U.S. Aggregate Bond Index is a broad-based fixed-income index used by bond traders and the managers of mutual funds and exchange-traded funds (ETFs) as a benchmark to measure their relative performance. Morningstar LSTA U.S. Leveraged Loan Index is designed to deliver comprehensive, precise coverage of the US leveraged loan market. Underpinned by PitchBook | LCD data, the index brings transparency to the performance, activity, and key characteristics of the market. S&P 500 Index is a stock index that tracks the share prices of 500 of the largest public companies in the United States. Formally known as the Standard & Poor’s 500 Composite Stock Price Index and commonly referred to as the S&P 500, it’s one of the main tools used to follow the performance of U.S. stocks. Bloomberg U.S. Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by U.S. and non- US industrial, utility and financial issuers.
Risks—Investing involves risks. Some investments are riskier than others. The investment return and principal value will fluctuate, and shares, when sold, may be worth more or less than the original cost. Alternative investments often engage in leverage and other investment practices that are extremely speculative and involve a high degree of risk. Such practices may increase the volatility of performance and the risk of investment loss, including the loss of the entire amount that is invested. Private investments are subject to liquidity risk which constitute illiquid investments for which there is not, and will likely not be, a secondary market at any time prior to a public offering and listing of our shares on a national securities exchange. Diversification and asset allocation do not guarantee profit or protect against loss.
The views expressed herein are those of PGIM Private Capital investment professionals at the time the comments were made and may not be reflective of their current opinions and are subject to change without notice. Neither the information contained herein nor any opinion expressed shall be construed to constitute an offer to sell or a solicitation to buy any security.
Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. The manager has no obligation to update any or all such information, nor do we make any express or implied warranties or representations as to the completeness or accuracy. Any projections or forecasts presented herein are subject to change without notice. Actual data will vary and may not be reflected here. Projections and forecasts are subject to high levels of uncertainty. Accordingly, any projections or forecasts should be viewed as merely
representative of a broad range of possible outcomes. Projections or forecasts are estimated, based on assumptions, subject to significant revision, and may change materially as economic and market conditions change.
This material is being provided for informational or educational purposes only and does not take into account the investment objectives or financial situation of any client or prospective clients. The information is not intended as investment advice and is not a recommendation. Clients seeking information regarding their particular investment needs should contact their financial professional.
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