The private credit asset class has grown immensely since the Great Financial Crisis (GFC). In Part I of this blog series, we discuss the recent evolution of the lending market, define the below investment-grade (IG) universe and outline direct lending, which is a core component of private credit.
Before the great financial crisis (GFC), banks played a large role in lending to public and private companies. Post GFC, banks largely reduced their financing operations due to tighter lending restrictions and more stringent government regulation on capital requirements. As bank lending capacity diminished, creative financing structures and non-bank lenders stepped in to fill the void.
Commercial Banks in the U.S.
Exhibit A: Number of Commercial Banks in the U.S. Source: FRED, St. Louis Fed
Lender Composition of the Leveraged Loan Market
Exhibit B: Lender Composition of the Leveraged Loan Market Source: S&P LCD Research
As shown in Exhibit B, banks lost approximately 14% of the leveraged loan market share over the last decade, leaving Collateralized Loan Obligations (CLO’s) and non-bank financial institutions to fill the void. The same holds true in the private middle market. From a GDP perspective, the U.S. middle market segment is the third-largest economy in the world. Given that 200,000 middle market companies equal approximately 1/3rd of U.S. GDP, it’s simple to see why non-bank institutions have increased their footprint.
Size of the U.S. Middle Market Relative to Other Global Economies
Exhibit C: Size of the U.S. Middle Market Relative to Other Global Economies Source: Churchill AM
Before diving into private credit, let’s first define the overall lending environment within the context of the below investment-grade (IG) universe. The below IG universe is defined as any fixed income security with a credit rating below Baa3 according to Moody’s or BBB- according to S&P.
A leveraged loan is a form of corporate financing that typically facilitates mergers & acquisitions (M&A), leveraged buyouts (LBOs), and recapitalizations. Loans are typically senior-secured and placed at the top of a corporation’s capital structure. Loans are floating rate (i.e. coupon regularly adjusts alongside interest rates) and usually have attached covenants that protect a lender in the event of credit default or deterioration. Loans differ from high yield bonds given the former’s position in the capital structure and the lender protections via covenants.
Leveraged loans are publicly issued through the broadly syndicated loan market (BSL). Broadly syndicated loans are tied to corporations that generate in excess of $50 million in EBITDA (earnings-before-interest-taxes-depreciation-amortization) or are $250 million-plus in total loan size according to S&P Global).
Exhibit D: Leveraged Loan & HY Bond Characteristics Source: S&P Global
Lastly, collateralized loan obligations (CLOs) pool together many different leveraged loans and securitize out various debt and equity tranches by return and risk. CLOs continue to absorb a large portion of leveraged loan supply given the structure’s popularity.
Private credit (also synonymous with private debt) consists of various strategies including direct lending, mezzanine, asset-based lending, special situations, bridge financing, distressed, real estate, and venture debt. Direct lending is the largest of the debt strategies and can be considered a “core” type of financing for the middle market (generally referred to as corporations earning between $20 million to $1 billion in annual revenue). Similar to the leveraged loan market, financing in the middle market consists of senior-secured, floating rate loans where the use of proceeds includes M&A, leveraged buyouts (LBOs), and recapitalizations. Unlike leveraged loans, middle market direct loans are privately negotiated by a sole or small group of lenders and are typically smaller in size.
Exhibit E: Direct Lending (Middle Market) Characteristics Source: Angelo Gordon, S&P Global
By accounting for illiquidity and complexity, middle market loans out-yield public leveraged loan equivalents. For example, through the end of 2010 to 2020, the additional yield premium received from direct lending relative to public market high yield was approximately 400 basis points on average1. Exhibit F illustrates the yield difference by showing the historical current yield of the direct lending market relative to public high yield.
Private Debt vs. High Yield
Exhibit F: Private Debt vs. High Yield Source: Cliffwater Direct Lending Index, FRED
Middle market loans are either sponsor-backed (private equity firm is involved in the transaction and owns a meaningful equity stake in the underlying company) or non-sponsor-backed (family-owned or not backed by a private equity firm). Loans are typically first lien (top of the capital structure, senior priority) but can also be second lien or unitranche (a loan structure that combines senior and junior debt).
In Part II of the private credit blog series, we will discuss the merits and risks of direct lending relative to other types of private credit and alternative investment strategies. We will also dive into asset allocation and how to think about private credit in the context of a diversified portfolio.
1. The Cliffwater Direct Lending Index (CDLI) and BofAML Master High Yield II Index were used in calculating the average yield spread through 2010 – 2020.
2. Table Definitions
• OID (Original Issue Discount): the discount in a the price of a bond at issuance, usually 1 or 2 points below par
• PIK (Payment-in-Kind): allows a borrower to make interest payments with other methods besides cash
• Prepayment: lender obtains additional economics if borrower pays off the loan prior to maturity
• Sponsor (PE): refers to a private equity firm
• 1st Lien: a senior revolving loan or term loan secured by a first lien on all assets, cash flow and stock of the borrower. The lender is in a first priority position and will be repaid first in a liquidation or bankruptcy waterfall
• 2nd Lien: a term loan secured by a second lien on all assets, cash flow and stock of the borrower. The lender ranks behind the first lien lender in terms of security and waterfall, but not necessarily in right of payment
• Unitranche: a term loan combining senior and subordinated tranches of debt into one facility with a blended interest rate
This article was written by Loren Asmus, CFA, CAIA, Vice President, Investment Research. Mr. Asmus is a shareholder and part of Canterbury’s Research Group. He is responsible for the sourcing, due diligence, and monitoring of public market investment managers. He serves as chair of Canterbury’s ESG, Fixed Income, and Real Assets Manager Research Committees, and vice chair of the Hedge Funds Committee. He also sits on the Capital Markets Committee. Mr. Asmus joined Canterbury in 2013 as an analyst serving institutional and taxable clients. Prior to Canterbury, Mr. Asmus was an institutional fixed income representative for Mutual Securities, LLC, where he provided fixed income solutions for county and city municipalities. Mr. Asmus graduated with a Bachelor of Arts from California State University, Fullerton, where he double majored in business administration, finance, and music performance, jazz studies. He is a CFA® charterholder and a Chartered Alternative Investment Analyst.