The global private credit market has been on a canter

Outstanding private credit stood at $1.6 trillion in early 2024, compared with $1 trillion in 2020, marking a compound annual growth rate of ~16%. By 2028, this market is expected to grow another 75% to reach $2.8 trillion¹. The US had ~70% market share, followed by Europe. Asia-Pacific is also showing strong growth potential amid promising economic prospects.

Banks unable to tap the private credit opportunity since years

The ascent of private credit has been shaped by pivotal events in recent financial history with exposure moving away from banks: the 2008 Global Financial Crisis, historically low interest rates in the 2010s, the Covid-19 pandemic and the regional banking turmoil of the 2020s.

• 2008 Global Financial Crisis: In the aftermath of the crisis, the Dodd-Frank Act was introduced in 2010, designed to curb risk-taking and enhance regulatory scrutiny. The legislation hampered access to availability of loans from traditional banking system for companies lacking credit credentials, thus unveiling a fertile ground for private credit to flourish
• Era of low interest rates (2010s): With the Federal funds rate lingering at a mere 0.25% from 2010-2015 and peaking at just 2.5% in 2019, investors were compelled to pursue higher yields. This search for attractive returns propelled private credit into the spotlight, as it emerged as a compelling alternative to traditional fixed-income avenues. Meanwhile, banks maintained a cautious approach towards the private credit, mainly due to strict regulations that require them to maintain significant capital reserves, limiting their flexibility
• Pandemic and the banking crisis (2020s): The onset of Covid-19 wreaked havoc on markets and daily life, yet the subsequent economic reopening in 2021 ignited a record-setting wave of M&A. However, soaring inflation prompted the Federal Reserve to implement the swiftest rate hikes in decades during 2022 and 2023. As banks grappled with a backlog of unprofitable loans, traditional lending contracted, allowing private credit firms to seize the opportunity and capture a substantial share of bank’s portfolio

Banks are now ready to embrace the private credit market

Banks have started to show interest in the private credit market by actively increasing their lending into the broadly syndicated loan market — the fundamental way to finance leveraged buyouts. During the first quarter of 2024, as many as 28 companies arranged bank loans to refinance $11.8 billion of debt that was previously provided by private credit firms³.

There are increasing opportunities for banks to gradually get back into this space, while remaining within the bounds of their regulatory frameworks and effectively managing risks by keeping the loans largely off their balance sheets. One such lucrative opportunity is in the form of sizeable upcoming maturities of the high-yield (HY) and leveraged loans (LL) including commercial real estate (CRE).

Fillip ahead from looming maturity wall in LL/HY and CRE

A looming stack of spec-grade CRE and HY debt due to be refinanced over the next four years is presenting an opportunity for banks to reconsider their role in meeting the demand for private credit market. According to S&P, ~$441 billion of spec-grade borrower loans are due in the next three years⁴, while MUFG outlines ~$175 billion of HY debt and ~$300 billion of LL debt due in the next two years⁵. Further, ~$950 billion of CRE debt is due by the end of 2024, likely reaching a peak of ~$1.3 trillion by 2027⁶. The presence of these high-maturity walls, coupled with the necessity for loan refinancing, opens a realm of opportunities for banks to engage with the market. In addition to direct lending options, financial institutions are also unveiling other innovative strategies to capitalise on the refinancing demand and adeptly satisfy their regulatory obligations.

Banks exploring multiple avenues to broaden their reach in the private credit landscape

Banks are using innovative channels to return to the market, lured by attractive return-generating opportunities and the diversification of risk and exposure, while they face steep competition from private equity funds, hedge funds, speciality finance companies and institutional investors like pension funds, insurance companies, sovereign wealth funds, etc. Some of the most prevalent recent strategies include:

• Partnerships with private lenders: Banks are constrained in lending to riskier clients due to regulations, while private credit firms operate with fewer restrictions. Strategic partnerships between the two allow banks to connect their corporate clients with private credit firms, effectively offloading credit risks. This collaboration enables banks to leverage the private credit firm’s capital while providing the latter with access to its established client relationships, enhancing service offerings and market reach for both parties. The Citi-Apollo’s $25 billion private credit and lending partnership is the latest big-ticket tie-up. Other major players such as Goldman Sachs, Morgan Stanley, Wells Fargo, Mizuho and Société Générale SA have also used the preferred partnership route with private credit funds
• Symbiotic relationship with private lenders: Some banks are opting to cooperate with private credit firms by offering services such as wealth management and advisory. For instance, Morgan Stanley, Merrill Lynch and UBS are distribution partners of Blackstone’s private credit funds which target high-net-worth retail investors. Also, HSBC connects its mid-corporate clients with private debt funds for customised lending solutions, while earning commissions
• Deploying own capital with tailor made solutions: Banks are deploying their own capital to develop their private credit capabilities. Banks are ramping up their involvement in broadly syndicated loans, offering competitive rates to attract borrowers. They are also diversifying their focus to provide customised financing solutions like flexible repayment terms, less restrictive covenants, etc. to meet the specific needs of borrowers. However, this route is contingent on factors such as risk appetite and size of the venture

Challenges banks face as they make inroads

• Tight regulations: The anticipated adoption of Basel III Endgame capital requirements may restrict banks’ capacity to lend to high-risk clients. In contrast, private credit firms, which are non-banks entities, typically encounter fewer regulations. This could lead to a transfer of credit from banks to private credit lenders, causing the banks to forfeit underwriting fees to these private funds
• Deterioration in the credit quality of borrowers: The current high inflationary environment and increased costs for businesses may lead to a deterioration in credit quality, particularly among lower-rated borrowers, indicating that defaults could rise in the coming years
• Increased competition among lenders: Heightened activity in the broadly syndicated loans market has intensified competition, slashing prices and prompting the refinancing of certain private credit loans with syndicated debt. This increased competition may impact the underwriting standards, creating an intricate landscape should borrowers encounter servicing challenges or defaults. Customised solutions may be needed for more complex credits, potentially commanding a premium. Yet private credit is expected to retain its strong position in the mid-market, providing sophisticated financial solutions to smaller firms, while large-cap deals continue to be competitive
• High interest rates: As customers borrow at floating interest rates, a higher-interest-rate environment poses a challenge as high-risk borrowers may not be able to generate sufficient cash flows to adequately service debt. Most borrowers have just enough cash to cover their interest payments. IMF estimates that one-third of borrowers have interest costs exceeding their cash flow
• Asset Illiquidity: Valuation of illiquid assets is another challenge, given the lack of comparable transactions/assets, often exacerbated by data scarcity, contributing to illiquidity
   

Navigating the tempestuous seas

Persisting concerns around stringent banking regulations could restrict banks from extending their loan book to leveraged borrowers in the private credit space. In the milieu, a comprehensive suite of strategies is the need of the hour in navigating through market risks.

The imperatives include stringent underwriting standards during deal originations with appropriately crafted covenants, carrying out meticulous borrower assessments to evaluate creditworthiness and ensure astute risk pricing.

Sharp focus on borrower performance and macroeconomic indicators, complemented by robust covenant monitoring and conducting rigorous stress tests can help in identifying potential warning signals and accordingly prompting lenders to take necessary actions to prevent defaults.

Also, valuation of private debt instruments is critical during origination as it impacts the decision-making process. A sophisticated approach is essential, encompassing meticulous due diligence, insightful cash flow analysis and comprehensive risk assessment.

Simultaneously, periodic valuation is also necessary considering a volatile macroeconomic landscape that can undermine investor confidence. Continuous scrutiny and recalibration of valuations are crucial, requiring regular reassessment of assumptions and adjustment of methodologies to align with shifting market dynamics. Additionally, engaging independent validators enhances credibility by revealing gaps and improving accuracy.

Private credit will continue to play a key role in debt markets. As banks seize the burgeoning opportunities within the private lending space, their strategic adaptability and innovative approaches will be key to not only enhancing their competitive edge but also reshaping the future of financing in this dynamic market.

¹Private Credit Market: 2024 Outlook & Opportunities | Morgan Stanley
²Private Credit Markets – A Growing Force | Mariner (marinerwealthadvisors.com)
³https://www.ft.com/content/bd3c91f2-ded2-45ed-bc6d-7db99fe42d39
⁴Credit Trends: Global Refinancing: Maturity Wall Looms Higher For Speculative-Grade Debt | S&P Global Ratings (spglobal.com)
⁵mufgamericas.com/sites/default/files/document/2023-07/chart-of-the-day-6-29-corporates-moving-opportunistically-to-pre-fund-2025-hy-maturity-wall.pdf
⁶https://www.spglobal.com/marketintelligence/en/news-insights/research/commercial-real-estate-maturity-wall-950b-in-2024-peaks-in-2027