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By Valerie Hernandez, International Banker
A late-October public filing by Pacific Investment Management Company (PIMCO) revealed that the American investment-management firm, best known for its sizeable fixed-income market presence, had raised $2 billion for a new asset-based finance strategy (for example, equipment-based lending and aviation finance) and its forays into consumer debt (e.g., credit-card receivables and non-consumer loans). The fundraising means PIMCO becomes the latest in a long line of financial firms pushing more aggressively into the booming private-credit realm, with asset-based finance (or specialty finance) fast becoming the next major gold rush within the sector.
Also known as private debt, private credit involves extending financing to borrowers—typically small and medium-sized businesses (SMBs) that are often highly leveraged—by nonbanking financial institutions. This credit is privately issued and is never traded publicly, unlike fixed-income assets, such as corporate bonds and public high-yield debt. It also tends to be lighter on supervision as it sits outside of the highly regulated banking system.
Private credit offers distinct benefits to borrowers, lenders and investors compared with public fixed-income bond markets. For instance, borrowers of private credit have often faced roadblocks when trying to obtain funds through more traditional banking channels. Private-credit solutions, finely tuned with respect to loan size and the timing of transactions, also offer more flexibility to borrowers.
The wide range of nonbank financial lenders, meanwhile, typically includes private-credit funds, private-equity firms, hedge funds and other sizeable institutional investors, with behemoths such as Blackstone, Apollo Global Management, Ares Management and Blue Owl Capital emerging as the biggest names in the space. Apollo, for example, managed almost $700 billion in assets as of June 30, more than $500 billion of which came from its credit business. And given the illiquid nature of private-credit markets, these lenders are able to price in a much greater spread—possibly as much as 300 basis points (bps) in some instances—than other fixed-income segments, such as leveraged loans and high-yield bonds.
On the investor side, recent years have seen a range of institutional entities, pension funds, insurance firms and sovereign-wealth funds increasingly adding private credit to their portfolios as a potentially higher-yielding alternative to traditional fixed-income strategies. These end investors are pouring substantial sums into private-credit funds designated for lending to corporate borrowers. “Although private credit accounts for a relatively small share of the total outstanding debt of private companies, at around 15 percent, it has experienced substantial growth since the GFC [Global Financial Crisis of 2007-09] and has become an increasingly important source of credit for businesses, with aggregate outstanding volumes comparable to leveraged loans and high-yield corporate bonds,” Federal Reserve System (the Fed) senior economists Ahmet Degerli and Phillip Monin noted in early August.
Indeed, while public-debt markets have suffered dramatically in recent years, with declining bond prices and soaring yields, private credit has gained hundreds of billions of dollars in assets. Morgan Stanley has estimated the private-credit market’s global assets under management (AUM) at the start of 2024 at approximately $1.5 trillion, a 50-percent expansion from the $1 trillion the bank recorded in 2020. According to the “Preqin 2024 Global Report: Private Debt”, private credit’s global AUM will reach $2.8 trillion by 2028. BlackRock, one of the world’s largest asset managers, meanwhile, has forecasted an even more eye-popping $3.5 trillion in AUM being registered by the same year.
And with no end in sight to this megatrend, massive structural changes across financial services are in the offing, particularly as the banking industry continues to be outmuscled for private-credit business by nonbank lenders. “There’s been a secular shift from lending in the banking system to the nonbanking system, where savers are acting as lenders, and we think that’s a trend that will stay intact,” Greg Olafson, global head of private credit at Goldman Sachs Asset Management, recently explained to investment publication Pensions & Investments. “Ultimately, it’s a better business model, and there’s better asset-liability matching.”
It shouldn’t be surprising that banks are increasingly partnering with private-credit fund managers to access the outsized returns and substantial fees this sector is currently yielding. In turn, fund managers can gain access to the often extensive list of existing borrower relationships that their banking partners possess.
“Private credit firms can help banks maintain their client relationships in the corporate lending market. For example, banks can play the role of facilitator by creating connections between their corporate clients and private credit firms. Corporate clients may benefit from faster and more flexible lending terms, while private credit firms benefit from the bank’s relationships,” according to Deloitte. “For banks, one advantage of working with private credit firms is retaining less credit risk. With the expected adoption of Basel III endgame capital requirements, banks may be limited in their ability to lend to riskier clients. However, since private credit firms are nonbanks, they often face fewer regulations. Working in partnership may help banks provide better service to their corporate borrowers.”
While direct lending—whereby the lender directly provides secured or, less commonly, unsecured funding to a corporate borrower (with corporate recourse included)—has been the most popular type of private credit to date, it is asset-based private credit that has more recently grown in interest, as investors and asset managers such as PIMCO increasingly perceive this segment as the highest-yielding business within private lending.
“In the fast-growing private credit universe, interest is building around asset-based lending (ABL), a sector that offers compelling and consistent diversifying return potential. Also referred to as asset-backed or specialty finance, we consider it the $20+ trillion next frontier of private credit,” PIMCO states on its website. “Often secured by hard assets as collateral, it provides critical funding across the global economy in residential mortgage, consumer credit, and non-consumer lending.”
Indeed, banks have increasingly been keen to tie up partnerships with private-credit managers in this particular area, with Barclays’s deal with Blackstone, BNP Paribas’s deal with Apollo Global Management and Société Générale’s deal with Brookfield Asset Management (BAM) falling under the category of asset-based lending or specialty finance. “Asset-backed lending has emerged as a significant market opportunity within private credit, as clients increasingly look to diversify their private credit exposure beyond only direct lending,” Ali Dibadj, chief executive officer of $330-billion British-American global asset-management group Janus Henderson, said regarding the firm’s acquisition of private-credit manager Victory Park Capital, completed in early October.
Not everyone is fully on board the private-credit train, it must be noted, with the traditional banking industry being forced to confront the new trend of massive sums leaving its shores and ending up with nonbanking lenders. “A lot of those folks who took private credit loans will be stranded when the shit hits the fan, because they can’t roll over a loan at 14 percent. Their company won’t be able to afford it,” JPMorgan Chase’s chief executive, Jamie Dimon, warned investors in May. “So, banks tend to work with the borrower and the middle market loan in the crisis; we’re getting LIBOR plus 1.75 percent; maybe you’re going to charge them LIBOR plus 2.25 percent, because we want them to survive. In the mark-to-market world of private credit, they have to, as a fiduciary, book it at par, which means they have to roll over at 14 percent. Private credit hasn’t dealt with high interest rates, hasn’t dealt with a recession, and it hasn’t dealt with high spreads.”
The exodus of funds away from the highly transparent, highly regulated banking system and towards the more opaque private-credit sector is also raising significant concerns among regulators, with many warning about the systemic risks that shadow lending holds for the global financial system. According to the International Monetary Fund’s (IMF’s) April 2024 “Global Financial Stability Report”, the sector continues to demonstrate meaningful vulnerabilities; it remains opaque to stakeholders; and it is expanding under less regulatory oversight than the traditional banking sector.
Recent evidence suggests, moreover, that fewer credit managers beyond the biggest players in the space are now enjoying the private-credit bonanza, with both Fidelity Investments and Polen Capital failing to make significant headway in their European direct-lending businesses and thus shuttering their operations in this sector. “If you want to talk to the biggest companies then you need the biggest pockets of capital,” Rob Seminara, Apollo’s head of Europe, acknowledged in early September. “We will continue to see bigger managers grow in scale as they’re much more relevant to the biggest companies in the world. Private credit is a real enabler to them.”
Nonetheless, private credit’s ongoing outperformance should persist well into 2025 and possibly even beyond and position it among the most compelling asset classes for investors for the time being. “Since the global financial crisis, when private credit began growing in earnest, direct lending (the most common type of private credit) has provided higher returns and lower volatility compared to both leveraged loans and high-yield bonds,” Ashwin Krishnan, co-head of North America private credit at Morgan Stanley Investment Management, noted in June. “In particular, direct lending has outperformed in high and rising rate environments. When measured over seven different periods of high interest rates between the first quarter of 2008 and the third quarter of 2023, direct lending yielded average returns of 11.6 percent, compared with 5 percent for leveraged loans and 6.8 percent for high-yield bonds.”
