Private credit has risen in popularity over the last two decades. Over the last year, analysts have been predicting that the impending debt maturity wall for U.S. corporate bonds could accelerate private credit’s growth. As companies are expected to roll over most debt rather than settle it, they face an entirely different interest rate environment, including potential interest penalties for refinancing.

Private credit offers companies quicker execution, less susceptibility to swings in the market and the potential to defer interest payments, which is typical in private credit agreements. For these reasons, it may be an attractive alternative to high-yield bonds or traditional lending. 

The downside of private credit is that floating interest rates can push companies to the brink, even when interest payments are deferred (as is often offered with private credit arrangements). Regardless of the source of capital, higher rates are going to force companies to roll over less debt—leaving a void for investment to fund growth.

How did we get here?

Three main periods of the recent financial markets have contributed to the growth of private credit: the 2008 global financial crisis, the ultra-low interest rate environment of the 2010s, and the global pandemic and regional banking crisis of the 2020s. The chart summarizes the growth of private credit assets under management (AUM) over these periods and the forecasted boom through 2028.

In 2010, the U.S. Congress passed the Dodd-Frank Act, aimed at reducing risk-taking and increasing regulatory reporting in the financial markets in the wake of the global financial crisis. As a result of Dodd-Frank, some fledgling industries that lacked credit credentials, such as start-ups in the technology space, found it harder to get loans from traditional banks.

After the financial crisis, the U.S. entered a period of ultra-low interest rates. From 2010 through 2015, the federal funds rate stayed at 0.25%, a record low. The peak rate during that decade was 2.5% in 2019. As a result of the low rates, investors started searching for higher returns, with many finding private credit an attractive alternative.

Then, in 2020, the COVID-19 pandemic disrupted the markets and daily life. As vaccines eventually enabled a broader economic reopening, 2021 set records for M&A activity. But high inflation caused the Federal Reserve to hike rates at the fastest rate in over 35 years in 2022 and 2023. The increased interest rates left many banks with a backlog of unprofitable loans for buyout deals that were arranged before the hiking cycle. The resulting hung debt, estimated at $80 billion in 2023 according to Bloomberg, preoccupied many banks, which made fewer loans while cleaning up their own balance sheets. Again, this opened the door and allowed private credit to boom.

Private credit funds private equity

Private credit within private-equity-leveraged buyouts is not a new phenomenon. Private credit has funded over 73% of leveraged buyouts since 2020, according to PitchBook. However, two new types of loans are gaining popularity within private equity: net asset value loans (NAV loans) and management company loans (manco loans).

NAV loans are collateralized by a pool of portfolio companies. Private equity firms have been using NAV loans to grow their portfolios or return money to investors. The latter has been very attractive to private equity firms in the current environment. As the pace of exits has declined and as fundraising has been difficult, NAV loans free up the firms to fund existing commitments or get return to investors without exiting a portfolio at an unfavorable multiple or discounted valuation. NAV loans totaled approximately $100 billion in 2023, according to private equity firm 17 Capital, with analysts expecting a 10-fold increase by 2030 to $1 trillion.

Manco loans are newer, with less hard data regarding their popularity or the quantum of loans. These differ from NAV loans in that the loan is typically taken by the management company or entity overseeing a specific investment. Further, manco loans are collateralized by the cash flows and equity returns of a private equity firm’s investment. The proceeds from the loans often fund new strategies or succession planning.

Is it worth it?

Private credit has been seen as a relatively safe investment versus bank-syndicated loans in the space, with a default rate of 2.3% according to KBRA Analytics. Additionally, returns in 2022 and 2023 were in the low teens—on par with private equity investments—while maintaining a lower risk. But some researchers are questioning if it is all too good to be true.

A March 2024 study from the National Bureau of Economic Research argued that “direct lenders on the whole hardly produce any alpha—or extra compensation over broad market benchmarks.” The researchers argue that broadly speaking, any gains above broad market benchmarks are effectively reduced to zero once fees are paid to the fund managers.

Future outlook

The sector is going to face headwinds in the future as investors question the returns. Further, regulatory scrutiny is likely to increase. On April 8, 2024, the International Monetary Fund released a report noting that private credit “warrants closer watch.” Analysts are already waiting to see if the U.S. Securities and Exchange Commission tightens regulation to make it more similar to traditional banks. Regardless of the outcome, it is likely that private credit will continue to play a key role in debt markets, providing funding to bridge gaps underserved by syndicated loans and traditional debt markets.