(Editor's Note: Private Markets Monthly is a research offering from S&P Global Ratings, providing insightful interviews with subject matter experts on what matters most across private markets. Subscribe to receive a new edition every month: https://www.linkedin.com/newsletters/private-markets-monthly-7119712776024928256/)

As investors increasingly allocate capital across the private debt markets and macroeconomic and financial conditions evolve, investors may necessitate greater transparency. Private Markets Monthly is S&P Global Ratings' new monthly research offering, where Head of Thought Leadership Ruth Yang interviews subject matter experts on what matters most across private credit markets now and moving forward.

This month, Ruth interviews Andrew Watt, Managing Director and the Head of Financial Services, Infrastructure & Alternative Asset Ratings for the Americas at S&P Global Ratings. Prior to this role, he was the Head of Corporate Ratings for the Americas. For over 20 years at S&P Global Ratings, Andrew has watched the large corporate leveraged finance and private credit markets grow and thrive through both bull and bear markets.

In this edition of Private Markets Monthly, we discuss our views on today's private debt markets as they face rising costs of funding and challenging economic times.

What has spurred growth of the private credit (direct lending) market in the past 10 years?

Institutional investors with fixed-income allocations—such as insurers, pensions, and sovereign wealth funds—have been a main driver of the explosive expansion of the private credit market. The attraction for them is fairly simple: the prospect of higher yields relative to other fixed-income assets in a protracted low-rate environment, along with the expectations for consistent risk-adjusted returns.

This increased allocation of capital has not only lured more asset managers, but also attracted more private equity sponsors looking for alternatives to fund small- to mid-market deals in their portfolios. In the U.S., this attracted other private credit providers, including specialty finance companies, business development companies (or BDCs, which were created by an act of Congress in 1980 to provide capital to small and medium-size borrowers), middle-market collateralized loan obligations (CLOs), and banks. Many of the largest lenders in the private credit market have platforms that encompass several vehicles that hold private debt, enabling deals to grow ever larger.

Will this growth continue?

Likely, yes—the explosive growth of the private credit market in the past 10 years looks set to continue, as investors remain relentless in their hunt for yield. Given the attractive returns in these markets during the decade-long expansion—with spreads that are typically wider than those for broadly syndicated loans (BSLs)—it seems likely that institutional investors will keep ramping up their demand for private debt.

Recently, the participation of larger private credit funds has contributed to the increase in deal size, with private credit providers writing bigger checks to larger corporations which were traditionally borrowers in the BSL and speculative-grade bond markets. The sharp jump in interest rates threw a hurdle into the BSL market, which opened opportunities for private credit funds.

And it's not just institutional investors that have become bigger players in private credit; individual investors, too, are being drawn to this asset class through private debt funds.

What's the appeal of private credit for borrowers?

Borrowers benefit because private transactions can be handled faster and with more pricing and terms certainty than deals with a large syndicate of lenders. In private credit, borrowers work more directly with lenders, allowing for quicker turnaround (roughly two months from inception to execution), and borrowers also know the pricing through their direct negotiations, instead of being subject to a syndicate's sometimes shifting conditions. Private credit lenders also provide more flexible and customized financial solutions for issuers in the market; something issuers are unlikely to get in a syndicated loan market.

That said, this "bear market capital" comes at a higher price—both literally and figuratively.

Also, when many middle-market companies were at risk of breaching financial maintenance covenants at the onset of the pandemic, private lenders amended deals to help borrowers meet near-term liquidity needs—including with agreements such as capital infusions and payment-in-kind (PIK) structures. While these transactions contributed to a rise in selective defaults among middle-market borrowers, they also helped to avert payment defaults, in exchange for increased equity stakes to the lender.

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

While BDCs' public filings suggest that private credit borrowers may have pushed out their maturities, the prospect of higher-for-longer interest rates means borrowers could suffer some liquidity strains. For companies whose business models require significant upfront investment, the need to prioritize liquidity could come at the expense of long-term growth.

In addition, if economic growth slows as much as we expect, this could squeeze profit margins of many smaller borrowers—especially since they may have more limited ability to pass through elevated costs. For example, the health care sector, which has fairly large representation in S&P Global Ratings' credit estimates, has seen a number of recent ratings downgrades.

But 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 who ultimately holds the risk.

What's S&P Global Ratings' role in the market?

S&P Global Ratings' role in providing credit opinions across a wide set of asset classes allows us to discern and convey our views about broader credit risks. We assign credit estimates to private credit loans that collateralize rated middle-market CLOs. A credit estimate is a point-in-time, confidential indication of the credit quality of an unrated entity or instrument. S&P Global Ratings has assigned credit estimates to more than 2,500 issuers of private credit loans with total debt of over $300 billion.

We also provide ratings and analytics on about 137 middle-market CLO transactions. Moreover, we provide ratings on most of the larger and well-established BDCs. It is interesting to note that approximately 1,400 of these borrowers with credit estimates are also BDC holdings. Finally, some rated insurance companies are also major investors in private credit. So our ability to demonstrate insights into this somewhat opaque market deliver a bit of clarity on overall credit risk.

Writers: Joe Maguire and Molly Mintz