Specialist private debt provides a significantly differentiated, and perhaps more flexible, offering than bank debt. Whilst banks remain a sound option to provide credit, they have shifted their lending practices in a number of ways including a focus on a shrinking universe of relationship-based borrowers as well as a move to larger borrowers with debt which can be placed into the syndicated debt markets.
Ken Brougher, Head of Private Debt and Special Situations
Is private debt a replacement for banks?
Specialist private debt provides a significantly differentiated, and perhaps more flexible, offering than bank debt. Whilst banks remain a sound option to provide credit, they have shifted their lending practices in a number of ways including a focus on a shrinking universe of relationship-based borrowers as well as a move to larger borrowers with debt which can be placed into the syndicated debt markets. The result has been bank loan terms which are less flexible and a growing gap between banks and middle market borrowers.
What is private debt and how does it differ from traditional bank lending?
Private lending is simply a bespoke lending solution provided by non-bank lenders which focus on, and are structured taking into account, the unique circumstances of each borrower. Traditional bank lending, in contrast, comprises lending from banks which are not always able to offer the same degree of flexibility to borrowers given their operational, institutional and regulatory limitations. Additionally, for a number of reasons including bank consolidation and a difficult credit environment, there has been a noticeable reduction in lending origination by bank lenders, contributing to a gap between lending supply and demand which has been increasingly filled by private debt lenders.
Passionate (talented) private lenders saw an opportunity to make a difference by focusing in this segment of the market. At Astra we have identified this increasing dislocation and have been active in this space since 2017 when the market size was just c.US$600 billion1. Over that time the private debt market has experienced exponential growth growing to US$1.6 trillion1 in 2023 and is projected to reach US$ 3.5 trillion by 20281. In Q1-Q3 2023 alone private debt lenders have raised US$ 152bn2 in capital which is a reflection of the growing interest in this space.
What does private debt have to offer?
To borrowers, in a quickly changing dynamic macro landscape, private debt lenders, who are not tethered to the more rigid requirements and limitations of the public syndicated loan market or PE sponsors, can adapt more quickly and provide more tailored debt solutions to meet their unique needs with more flexible terms and faster execution.
For Investors, private debt investments not only provide better absolute returns but also better risk adjusted returns for investors. The average direct loan YTD yielded 12.5%, roughly 300 bps more than the JP Morgan BB/B Leveraged Loan index which yielded 9.5%.3 And, with more disciplined bespoke credit enhancement terms, not dictated by the more generic requirements of PE Sponsors or the syndicated loan market, recoveries in private debt may very well prove to be superior. This is achieved through various structural features and other factors such as:
First, stronger and more robust lending terms tailored not only to meet borrowers’ needs but also to provide credit enhancement thus reducing the lender’s risk, such as more transparency and control.
Second, discerning origination and disciplined due diligence. Identifying corporates with good assets and business models which can benefit from the precise application of disciplined lending.
Finally, direct access to borrowers’ senior management with CEO and CFO essentially on speed-dial which allows more proactive and earlier intervention with borrowers. In private debt, firefighting starts long before a minor issue becomes a major problem and early action provides an ability to influence work out and increase recovery.
These structural mitigants (which are features designed to protect the lender, function like safety features of a car, such as airbags, ESP, emergency braking systems) are only utilised when needed but are indeed highly necessary to prevent an accident and reduce loss.
The level of recovery in a default scenario will lie in both the security one has and the experience of recovering the value embedded in that security. While the private debt sector may not have gone through such a cycle yet, many of the senior players sitting on their teams have.
What is the path forward?
The changing credit environment will likely require different factors to bring about success.
Being agile will be more relevant than being the biggest. When you are too big, you are the market and who wants to be the market when the market is becoming more challenging? In this sort of market climate a disciplined focus on selective lending, essentially ‘picking your spots’, is key.
The final point can make all the difference. Private lenders have an undeniable advantage over the banking sector: they have the ability to be opportunistic and lend swiftly when time is right, and the stakes are high.
Each investor, no matter what asset class they specialise in, will understand that this ability to be flexible is key in making investments at times where one benefits from superior entry points. This may well prove to be a contributor to future performance or at the very least mitigate some of the downside risk.
In Conclusion
Banks tightening lending standards has created a vacuum that private debt can fill. However, an experienced team of a specialist manager is critical to properly and efficiently exploit this opportunity in a disciplined and controlled manner which minimize risks.
Disclaimer
This article has been prepared by Astra Asset Management UK Limited (Astra). Astra is authorised and regulated by the UK Financial Conduct Authority and is registered as an Investment Adviser with the US Securities Exchange Commission, solely in relation to US persons. The article comprises Astra’s opinion, it is not investment advice and does not comprise a recommendation to enter into any transaction or to follow any investment strategy. Any future-looking statements may comprise hypothetical information, and you should carefully consider the risks inherent to such information when considering this article. Astra will not accept any liability based on the article or any errors or omissions therein. You should obtain professional advice before entering into any transaction or other investment decision. Capital invested is at risk, including of total loss.
References
- https://www.blackrock.com/institutions/en-us/literature/market-commentary/private-debt-primer-oct-2023.pdf
- https://www.preqin.com/insights/global-reports/2024-private-debt
- https://privatebank.jpmorgan.com/nam/en/insights/markets-and-investing/ideas-and-insights/can-private-credit-continue-to-perform
Additional sources
https://www.morganstanley.com/ideas/private-credit-outlook-considerations
https://www.gsam.com/content/gsam/uk/en/advisers/market-insights/gsam-insights/perspectives/2023/defaults-and-recovery-rates-in-private-credit.html