Has private credit’s golden age already ended?
Summary
- A more competitive market is a less profitable one
The HISTORY of leveraged finance—the business of lending to risky, indebted companies—is best told in three acts. High-yield (or “junk") bonds were the subject of the first. That ended in 1990 when Michael Milken, the godfather of this sort of debt, was sent to prison for fraud. In the second act, the extraordinary growth of private equity was financed by both junk bonds and leveraged loans, which require companies to pay a floating rate of interest rather than the fixed coupons on most bonds. Private-credit investors are now supplying the third wave of money.
Since 2020 such firms, which often also run private-equity funds, have raised more than $1trn. When interest rates rose in 2022 and banks stopped underwriting new risky loans, private credit became the only game in town. Wall Street chattered that its “golden age" had begun.
America’s $4trn leveraged-finance market now comprises junk bonds, leveraged loans and assets managed by private-credit firms, in roughly equal proportions. Yet owing to fierce competition to refinance debt and fund scarce new deals, private credit’s prospects may no longer dazzle. The industry’s fondness for ancient Greece (two big lenders are called Apollo and Ares) seems not to extend to the work of Hesiod. If it did, fund managers would know that what follows a golden age is not a platinum one, as with American Express cards, but the descent into a grim iron age.
Private-credit funds tout certainty and flexibility as reasons to borrow from them. Facing fewer lenders than in the “broadly syndicated" leveraged-loan market often means speedier dealmaking and more pliant terms. As high interest rates put balance-sheets under pressure, for example, borrowers of private loans are increasingly negotiating to defer their interest payments. But healthier firms can afford to shop around. Some are tapping hot public leveraged-loan markets to refinance pricier private debt. Analysts at JPMorgan Chase count more than $13bn of such refinancing deals this year, with borrowers securing coupons that are 1.6 percentage points lower on average. Private lenders have had to slash the cost of their loans to compete.
A barrage of fresh buy-out activity, which might have juiced returns, looks unlikely. Private equity remains locked in a painful stalemate. Funds are hesitant to sell stakes they bought when interest rates were low, lest they turn out to be worth less than previously imagined. Their investors, meanwhile, are becoming angstier about the slow pace at which paper returns become cold, hard cash. In a recent poll by Bain, a consultancy, 38% of investors did not expect dealmaking activity to bounce back before next year.
When it does, dealmakers are divided over the role private credit will play. One idea is that its funds will thrive only in periods where banks and capricious public markets become less keen to lend. Another is that borrowers may well take advantage of private credit at first, only to try to refinance their debts in the public market at an opportune moment. In truth, the most likely outcome is that the line separating public and private loans will become increasingly blurred. That would mean a busy future for private credit—but one that is more commoditised and less profitable.
Such a fate would be familiar. As the market for leveraged loans matured after the global financial crisis of 2007-09, many shed their covenants, which protect creditors. In other words, the loans became more like junk bonds. According to Moody’s, something similar is already happening in private credit, which historically boasted stronger protections for creditors. The rating agency says that “maintenance" covenants, which require borrowers to maintain a minimum ratio of profits to debts, are very rare in the larger deals that private-credit funds must now chase.
No wonder the smart money in private credit now wants to do more than simply grease the wheels of buy-out funds. Many see the biggest opportunity in more specialised pools of debt—everything from credit-card loans to supply-chain finance—which can be bundled together into private “structured" credit. Such debt is a critical component of private-markets firms’ aggressive expansion into the life-insurance business, and some banks are even partnering with asset managers to shed loan portfolios. The more assets these firms whittle from the banking system, though, the more likely regulators are to treat them like banks. Now that would be a real iron age.
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