Goldman Sachs is among the biggest players in the growing private credit market.
Source: Ramin Talaie/Corbis Historical via Getty Images

Private credit is growing, offering investors greater opportunities for returns as other assets sink and recession approaches.

Private debt funds raised $225.72 billion in 2022 to make potential financing deals, up from $128.49 billion for all of 2017, according to Preqin. Separately, total private credit assets under management — capital available for investment and the value of unrealized portfolio investments — by companies including Ares Management Corp. and KKR & Co. Inc. will nearly double to $2.3 trillion in 2027 from $1.2 trillion in 2021, according to the financial data company.

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This article is part of a series examining private equity's strategic shift, and how the asset class is adapting to changing market conditions. Click on the links below for the other articles in the series as they are published.

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The practice involves a group of lenders, largely institutional investors, lending to companies outside of public markets. This generally allows simpler deals between fewer parties, and lenders can have greater protections for their money in case of defaults. With the U.S. facing a likely recession in 2023 and broad declines in public markets, private credit is becoming more appealing to investors, especially as asset managers hit record fundraising totals and more companies seek private financing to fuel growth.

"Because private credit has grown so much, it's gotten more and more capital, which means that it's providing more and more loans to the market and competing more with banks," said Michael Weisz, founder and president of Yieldstreet, an online investment platform.

Still, the prospect of recession and rising costs related to interest rate increases threaten to squeeze companies' bottom lines, potentially leaving them at greater risk of nonpayment or default. The growing size of private credit funds also raises questions about its impact on the broader financial system and how the new, relatively untested asset class will perform in a potentially lengthy economic downturn.

Private credit's appeal

Typically, private credit agreements are negotiated with fewer parties than more traditional lending, including bank loans and publicly traded debt offerings. Private lenders typically hold on to loans longer than they would in public agreements, offering them more stable returns while also tying up liquidity that could cause issues in the event of a need for quick cash.

Even so, the deals are less sensitive to the market volatility that comes with publicly traded assets. Markets have had a wild ride in 2022, with the S&P 500 down 20%. Corporate bonds also took a beating with the S&P U.S. Investment Grade Corporate Bond Index down 13.7% while even government bonds could not offer any safety as the S&P U.S. Treasury Bond Index fell 11%.

By comparison, private debt is forecast to have annual average returns of 8.4% from 2021 to 2027, according to Preqin.

Another advantage that private credit offers lenders is floating rate structures, wherein borrowers pay interest rates on their debt that are subject to change based on economic conditions instead of a fixed rate. These are typically tied to a benchmark and include a credit margin.

Broad borrowing costs jumped in 2022 as the Federal Reserve raised benchmark interest rates by 4.25 percentage points. Outside the U.S., central banks around the world are raising interest rates to bring soaring inflation down.

"It's sort of a compelling risk-return proposition right now," said Bill Sacher, head of private credit at Adams Street Partners, a private markets investment manager. "You can get premium returns and still play defense at the same time."

Companies squeezed

While floating rate deals can offer investors protection against inflation and rising interest rates, they put more pressure on borrowers' bottom lines.

Private credit defaults rose in the third quarter of 2022, according to law firm Proskauer, which compiles a private credit default index. The default rate for U.S. dollar-denominated deals hit 1.56% in the third quarter of 2022, up from 1.18% in the prior quarter.

The rate peaked at 8.1% in the second quarter of 2020 and has since trended downward, with the third-quarter 2022 result showing "the first notable increase" in the past 18 months," according to Proskauer.

"Given the cyclical nature of the economy and the uncertainty around timing and duration of a recession, we are not surprised to see an increase in the default rate, especially in consumer-facing sectors where the pressure continues to grow," Stephen Boyko, co-chair of Proskauer's private credit group, said in an Oct. 26 statement.

The index reading is similar to the 1.6% default rate for U.S. speculative-grade companies, according to September 2022 data from S&P Global Ratings. The agency expects the rate will more than double in 2023, reaching 3.75% by September.

"Next year, financial conditions will be very tight, and, at the same time, economic growth is expected to slow," Ratings analysts said in a Nov. 21, 2022, report.

About 77 rated companies worldwide defaulted in 2022, five more than did throughout all of 2021, Ratings said.

Systemic implications

The growth of private markets has increased the amount of leverage in the financial system, according to Moody's Investor Service. Increased competition among potential private credit lenders is leading to weaker deal convents, offering potentially less protection to investors, and alternative asset managers that finance the deals of other alternative asset managers concentrate risk in the sector. Even as private credit remains untested by a prolonged economic downturn, many private credit managers have the means to work out troubled investments, according to Moody's.

"Lending is largely opaque, driving an accumulation of asset quality performance risks that may be hard for market participants and regulators to discern until it is too late to counteract," Moody's analysts led by Senior Credit Officer Neal Epstein wrote in a June 2022 report.

The rise of private capital has transferred the risk associated with credit from banks to pensions, sovereign wealth funds and others, said Josh Lerner, the Jacob H. Schiff professor of investment banking at Harvard Business School. Banks are regulated in ways that private credit groups and their backers are not, although regulation can sometimes be ineffective or introduce distortions, Lerner said.

"With the benefit of hindsight, it will doubtless be clear whether this was a healthy innovation or a problematic mutation," Lerner said. "But for now, it is hard to tell."

Even with the greater risk, the need for private credit lenders has become more important for the broader economy as banks have backed away from financing private equity deals, said Stephen Quinn, co-head of credit at 17Capital, an investment firm.

"It helps to get deals done, particularly as private equity-backed companies become increasingly important sources of economic growth, investment, innovation and employment," Quinn said. "For investors, it opens up new pools of investment diversification with strong risk mitigation in a growing market."

Growth expectations

The U.S. is likely to enter a mild recession in 2023, with GDP declines in the first and second quarters of about 1% measured at annual rates, according to S&P Global Market Intelligence economists.

Private credit will likely gain market share from commercial banks as economic conditions worsen because investors will be drawn to its returns, Preqin analysts led by R.J. Joshua wrote in a Dec. 14 outlook report.

A deeper recession, however, with more defaults or slower recovery rates — or both — could lead to greater write-downs for lenders and growing negative sentiment for private debt, the Preqin analysts wrote.

"However, while possible, this is an unlikely scenario. The central case is one of private debt remaining resilient in a difficult macroeconomic environment, and well placed for an economic recovery," the analysts wrote.

Near- and long-term demand for private credit is being driven by the record amount of private equity capital raised over the last three years, said Jamie Athanasoulas, a managing director at HarbourVest Partners, a private markets firm. There is a timeline for when all this dry powder needs to be deployed, which is putting pressure on the need to do deals. While economic uncertainty is muting deal activity, all that dry powder will require private credit, Athanasoulas said.

"It's a war chest that they have to spend because of the way their funds are structured," Athanasoulas said.