Private credit investing has seen steady growth in recent years, becoming the third largest asset class in private capital markets. It provides financing to private companies in need of urgent funding which traditional banks have largely abandoned, while also offering investors greater returns and new opportunities. Although COVID-19 has impacted the private credit sector, private debt funds have grown over the past decade and investor confidence in this asset class is increasing. Compared to the hesitance of traditional banks to lend to smaller-scale or higher-risk borrowers, private credit continues to expand, a lingering issue from the 2008 global financial crisis. SME borrowers tend to turn to private credit financing as it offers more customized terms while having longer durations. Meanwhile, private debt transactions can bring higher interest rates for lenders and investors, with aggregate returns of 7-9% in private credit markets, far exceeding the 4-6% yields of publicly traded high yield bonds.
Data shows significant AUM growth in private credit
Data from providers like Preqin forecasts private credit AUM to grow 73% by 2025 to $1.46 trillion, as investor demand for alternatives continues expanding. As of Sept 30, 2020, private credit assets nearly doubled among the 200 largest U.S. pension plans over the past year, rising 93.1% to $50.2 billion. Preqin also reported 592 private debt funds in market seeking $300 billion in commitments, with private credit managers expecting to deploy over $100 billion in loans to SMEs and middle-market companies in 2020.
Strong performance despite pandemic-related challenges
Although private credit has seen steady recent growth, it still faces challenges. Some see it as merely shadow banking, a misconception. Also, while institutional investors are increasingly allocated, their exposure in private credit is still far below that of publicly traded asset classes. More education on private credit performance is still needed among institutional investors, wealth managers, and other trusted advisors. Access has also historically been difficult for HNWIs, who would turn to private banks for private credit. However, new opportunities to access private credit through alternatives are breaking down this wall for HNWIs.
Private credit tailored for capital preservation or return maximization strategies
Private credit strategies can be split between capital preservation and return maximization approaches. Capital preservation strategies are similar to traditional sponsor-focused mezzanine and senior debt funds that seek to deliver predictable returns while protecting against losses. Return maximizing strategies have returns closer to private equity, usually achieved by purchasing distressed credit instruments. While mezzanine debt providers have led in private credit, they also see the opportunity to optimize asset allocation across categories by raising immense capital. Private credit’s huge growth potential is being realized, as institutional investors recognize its optionality in building differentiated risk-adjusted returns and yields through re-allocation across the capital structure.
Despite a challenging market backdrop, private debt has performed well, with Preqin projecting 73% AUM growth in private credit to $1.46 trillion by 2025, the second fastest growing alternative investment after private equity. It continues offering investors new opportunities and median returns above 20%. Private credit also adds portfolio flexibility as it can reside in various parts of a portfolio.