With liabilities emerging as a culprit in the Silicon Valley Bank collapse, market participants are likely to take a closer look at funding sources for private credit providers. They may actually like what they find.
Broadly speaking, the banking model relies on the availability of depositors, equity, and borrowings. All these factors depend on confidence in a bank.
Private credit providers can be somewhat insulated from the fickleness of financial markets, in part due to their underlying liabilities. These private credit providers are asset managers, and capital for the loans they make comes from institutional investors, pension funds, high-net-worth investors and sovereign wealth funds.
Their liabilities typically are diverse, ranging from revolving credits and bonds with staggered maturities to entities called collateralized loan obligations (CLOs), which overall have an exceedingly low historical default rate of 0.09%, according to S&P Global. One reason private loans are costlier to borrowers is that their underlying liabilities are more complex, and more expensive.
Private credit loans are placed into funds, business development companies (BDCs), and CLOs. They are not easily tradable, as are broadly syndicated loans. But there are still some opportunities to exit these investments.
In the case of a BDC, a holding can be traded, similar to one with a mutual fund. A fund can be structured with a pre-set redemption limit, such as 5% per quarter. If an investor needs to exit, a limited partner stake of a private credit fund can be traded in a developing secondary market for LP holdings.
But it’s exactly this challenge in exiting these investments that makes the capital attractive as a loan-funding source. Funds are typically locked in for roughly 6-10 years. But even after that time, they will not be forced to liquidate loan portfolios.
“Private credit was built out of private equity, where you needed capital to be locked in. From those roots, private credit had the same considerations,” says Ranesh Ramanathan, co-head of law firm Akin’s private credit practice.
“Private credit had already been growing at a healthy clip. As we look back on 2023, we’ll see it accelerate,” Ramanathan continues.
In many ways, private credit has taken over the role of a regional bank, providing directly originated loans to midsized corporate borrowers.
The loans traditionally would be buy-and-hold investments, to be kept on a bank’s balance sheet, as opposed to being packaged into entities and sold off, as was done with subprime mortgages ahead of the Global Financial Crisis.
As a result, borrower companies could have a relationship with their private credit lenders, working out issues when they arose.
That may sound like an ideal banking relationship, one more akin with a community or regional bank from a bygone era. Indeed, private credit providers often use the idea of “relationship lending” to market the alternative asset class.
But that’s where the comparison between private credit and a regional bank ends.
Following increased regulation in the wake of the 2008-2010 credit crisis, banks have backed away from lending to midsized companies. New compliance and capital requirements made this type of lending costlier to a bank, reducing potential profits.
Private credit providers moved into the space. These private credit loans were typically slightly more expensive than what a bank could offer. Early on, these loans developed a reputation as a “bear-market product,” providing a type of financing that was available at times when the syndicated loan market was too volatile to get deals done.
Helping their marketing efforts, private credit providers have long argued that the middle market was underserved. In fact, they were doing the vast middle market — a driver of the US economy and a huge creator of jobs — an enormous service by lending to them, according to private credit lenders.
One major difference between broadly syndicated loans and private credit loans is that private loans are not rated. The private credit providers argue that their buy-to-hold lending model means they are incentivized to choose the loans carefully. Ratings, therefore, are less important, and lenders can differentiate themselves by picking the best credits.
Of course, not every private loan investment will succeed. Defaults are increasing in private credit loans, as in the syndicated loan market. They are expected to rise this year as borrowers face higher interest costs and inflation, according to market participants.
And of course, a private credit lender can fall prey to pressures of frothy credit market conditions, and lend to weak borrowers. Indeed, heavy competition in the market, as more lenders piled into the segment, has over the past several years led to competition among lenders to provide borrower-friendly loan terms.
And since there’s no robust secondary market for private credit loans, lenders are stuck with them if a borrower company hits hard times.
New, improved CLOs
Helping a lender’s funding profile are changes to the CLO world, wrought by the previous credit crisis. These vehicles have been popularized by private credit providers, many of whom are focused on middle market lending.
The CLO structure of today is less risky than the collateralized entities such as CDOs and CMOs that existed before and during the 2008-10 cycle. Post-crisis CLOs provide more investor protection than pre-crisis CDOs, or even CLO “1.0” structures, with the inclusion of higher levels of subordination, shorter non-call and reinvestment periods, and tighter eligibility criteria for loan holdings. What’s more, CLOs actually own the underlying loans.
The middle-market CLO structure has attracted more direct lenders and private-credit firms over the last few years, as fixed-income investors chasing higher yields provide a source for financing capital needs of small/medium enterprise firms. (The fourth-quarter weighted average spread of middle-market CLOs tracked by Fitch Ratings was 5.41%.)
Middle-market CLOs offer investors a spread premium (currently ranging from 240 to 285 bps over Sofr for triple-A notes) against broadly syndicated CLOs, which have had an average triple-A spread of Sofr+205 bps so far in the first quarter.
Middle-market CLOs reached a peak issuance of 41 deals totaling $22.10 billion in 2021. That level fell to just $11.98 billion in 2022, a 46% decline, as spreads widened and managers had difficulty attaining the necessary excess spread to secure the “arb” between liabilities on debt securities and the cash flow from underlying borrowers. For context, CLO issuance in the broadly syndicated loan space retreated by 29% last year.
Prior to the market turmoil resulting from the SVB collapse, issuance of middle-market CLOs appeared to be rebounding in 2023, with $5.1 billion in activity across 11 deals through March 13, as triple-A note spreads have tightened to 258 bps, on average, from 265 bps in the fourth quarter, according to LCD. Nineteen percent of year-to-date CLO volume has come from middle-market CLOs, the highest share since LCD began tracking this data in 2011, and up from 9% in 2022 and from a roughly 12% average between 2016 and 2021.
While middle-market firms may be more vulnerable to rising interest rates and expected recessionary headwinds in 2023, market observers note middle-market CLO investors also see a benefit from lender agreements allowing for necessary deferrals and covenant waivers. They may also have a potential backstop in short-term revenue declines from their private-equity sponsors.
Middle market deals also exhibit lower expected annualized loss rates than BSL CLOs, according to panelists at a CLO investor roundtable discussion at last month’s SFVegas industry conference in Las Vegas. In addition, while not as liquid as BSL CLO securities, middle-market CLO notes reportedly trade at a premium of approximately 40 bps in the secondary market.