Private credit has long been an important source of funding for small and midsize borrowers in the U.S., working alongside the broadly syndicated loan (BSL) and speculative-grade bond markets. But it wasn't until the past decade that the private credit (direct lending) market has seen such explosive growth. As signs of credit stress emerge and defaults creep up, it remains to be seen whether this "golden age of private credit" can continue.

In this Credit FAQ, S&P Global Ratings looks at some of the credit dynamics in this burgeoning market.

Who are the primary lenders in private credit?

Asset managers are a key component of the private credit market in the U.S., with many operating lending platforms that include multiple vehicles, including business development companies (BDCs), private debt funds, middle-market collateralized loan obligations (CLOs), and interval funds. BDCs, in particular, are central players to direct lending as they were established by Congress in 1980 to improve the access of middle-market borrowers to the capital markets.

We've also seen an increase in pairings between alternative asset managers and insurers, in which the insurance company provides a source of perpetual capital for the lending platform.

How does private credit differ from the markets for broadly syndicated loans or speculative-grade bonds?

Typically, banks address the borrowing needs of larger, public companies—including working capital, which is met by revolving lines of credit ("revolvers") at the bank. In addition to revolvers, banks also provide term loans (which together with revolvers are collectively called "pro rata" loans). While U.S. public companies generally tap the bond markets for much of their borrowing needs, private companies mainly look to the BSL or private credit markets for their financing needs.

Private credit is a form of lending where sponsors or borrowers work directly with lenders—with private credit funds displacing banks and other financial intermediaries. Other forms include mezzanine lending, special situations, and structured credit. Credit funds can also focus on specific areas such as infrastructure or real estate, over and above general corporate lending. Private credit investment is typically from a fund overseen by asset managers, while investors in this asset class are mostly pension funds, insurance companies, and sovereign wealth funds.

How does private equity factor into the private credit markets?

Private equity (PE) is the capital provided by investment firms to companies for an ownership stake. The investment is in the form of a fund which has general partners and limited partners. PE firms seek to increase the enterprise value before selling their ownership in the company to a strategic investor or other financial sponsor, or taking the company public via an IPO. They enhance enterprise value by bringing in operational improvements, increasing efficiencies and reducing costs, and adopting strategies to gain scale and scope.

Through the protracted period of low interest rates, money managers increased their asset allocations to private credit amid the prospects of higher returns and the need to diversify. Private equity in the U.S. has more than tripled in the past decade, to $3.9 trillion, from $1.2 trillion. PE's growth was also fueled by public companies transitioning to the private markets by way of leveraged buyouts (LBOs). The transition has also been attributed to an increased cost of regulatory compliance and reporting for public filers.

What has spurred the explosive growth of private credit in the U.S.?

Much of the growth in the private credit market can be attributed to the promise of higher spreads and better returns during the years of historically low interest rates. Driven by the regulatory onus of increased capital requirements and guidelines on leveraged lending, many banks exited middle-market lending. Direct lenders stepped into that void and grew their lending and investor base, offering features that particularly appealed to borrowers—such as efficiency and speed of execution, greater pricing certainty, confidentiality, and the predictability of execution. On the lender side, the draw came from higher spreads, stronger control over loan documentation, the absence of market volatility, and relationship-based lending.

Indeed, a growing share of middle-market funding seems to be coming from the private market rather than BSLs, whose number has fallen sharply in recent years. Assuming PE sponsors still rely on debt financing to complete acquisitions, one explanation is that middle-market PE sponsors and companies are increasingly turning to private markets.

How has private credit evolved in the past decade?

In short, it's become bigger. The increase in available capital has facilitated larger private credit funds, which in turn has enabled private credit providers to write bigger checks to larger borrowers. Recently, private credit lenders have underwritten larger transactions for such corporate borrowers, which were traditionally in the realm of the BSL and speculative-grade bond markets. The swift increase in interest rates, coupled with volatility that caused a pause in the BSL markets, opened opportunities for private credit funds.

How will the rise in interest rates, combined with a possible economic downturn, affect the private markets?

While private credit borrowers may have pushed out their maturities through amend and extend transactions and utilized payment-in-kind (PIK) treatment to obtain more financial flexibility, the prospect of higher-for-longer interest rates means borrowers will be under credit pressure. This is especially problematic if economic growth slows and squeezes profit margins of many smaller borrowers—since they may have more limited ability to pass through elevated costs. For example, the services segment of the health care sector is clearly experiencing credit deterioration.

However, because less information is available on private debt than on public debt, assessing aggregate risk is difficult. The close relationship between borrowers and a small pool of lenders means that few are privy to the details of any deal. Furthermore, the distribution of the private loans within lending platforms involving BDCs, private credit funds, and middle-market CLOs make it difficult to track the level of risk in this market, and where the ultimate credit risk may lie.