Christian Faes is CEO of Faes & Co.
Private credit, a form of lending that provides financing to business entities by nonbank lenders, is becoming increasingly seen as an attractive asset class for investors. The growth in recent years has been substantial, with Morgan Stanley reporting, “the size of the private credit market at the start of 2024 was approximately $1.5 trillion, compared to approximately $1 trillion in 2020, and is estimated to grow to $2.8 trillion by 2028.”
With these sorts of stats, it is no surprise that private credit has caught investors’ attention and headlines in the financial and mainstream press.
What’s driving the momentum in alternative investments?
Over the past few decades, alternative investments have seen remarkable growth and become a mainstream component of a sensible investment portfolio. The momentum and investor appetite for alternative investments have been driven by a number of factors:
• The stock market isn’t what it used to be. There are far fewer companies listed on the stock market these days. In fact, the number of publicly traded companies in the U.S. has halved since the mid-1990s. In 1996, there were over 8,000 publicly traded companies, but by 2023, the number had fallen to approximately 3,700.
The value in public markets is heavily skewed to a small number of companies. The “Magnificent 7,” a group of seven major tech companies including Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta and Tesla, represent a significant portion of the stock’s market value. In June, these companies accounted for approximately 31% of the S&P 500’s market capitalization.
As a result, the stock market doesn’t provide investors with the same level of diversification as it did in the past. There are fewer companies to invest in, and the vast majority of value is in only a small handful of companies.
• Investors are seeking less volatility. Over time, investors have learned that while the stock market does generally trend upward, it can be incredibly volatile, exacerbated by increased participation in public markets from hedge funds and technology-enabled automated investment algorithms. Events including September 11, the financial crisis and Covid have provided reminders that the stock market is not a place to “put all your eggs in one basket” as an investor.
• The era of low interest rates generated a wider search for investment yield. Persistently low interest rates reduced the appeal of traditional fixed-income investments such as bonds, term deposits and generally cash in the bank. Investors seeking higher returns increasingly turned to alternative investments such as private equity, real estate, hedge funds and private credit.
What is private credit?
Private credit essentially refers to a loan provided directly to a borrower from an institution that isn’t a bank (commonly referred to as a nonbank lender). These nonbank lenders include a whole range of institutions, including private equity funds, hedge funds, insurance companies and large pension funds.
Borrowers enjoy flexible funding capabilities, which is in stark contrast to banks that are typically slow moving, highly regulated and marked by a cumbersome credit box and processes.
Private credit borrowers benefit from a direct relationship with their lender as the lenders are smaller, more nimble organizations that are better set up to have a direct relationship with their borrowers.
Private credit can involve providing finance to a whole range of borrowers, from funding real estate transactions to funding small businesses or large multinational corporations. In each instance, the lender can be a specialist in their area and capable of underwriting the borrower in their sector, building a direct relationship with the borrower, which also serves the borrower well.
And while private credit loans can often be more expensive because the lender doesn’t have the advantage of having capital as cheap as that of a bank, borrowers often prefer that they can develop a direct relationship with their lender and that the nonbank lenders can be nimbler and provide more flexible funding solutions. This relationship and flexibility can be trade-offs for a borrower who is frustrated dealing with large legacy banking organizations.
What’s driving the momentum in private credit?
Since the financial crisis, large banks and traditional financial institutions have been dealing with a number of challenges. At first, banks were distracted, handling the headache of working through legacy loan books in the aftermath of the financial crisis. Then came increased regulation and capital requirements, making it more difficult (and expensive) for banks to compete in certain lending markets and will likely continue in the foreseeable future. In March 2023, we again saw the vulnerability of the banking system with the collapse of Silicon Valley Bank and the reverberations throughout the U.S. regional banking system.
At the same time, over the past 15 years or so, the financial services landscape has been transformed by a new breed of finance company that is attacking traditional lending with a more customer-centric and technology-enabled approach—something banks struggle with. While the larger banks have invested huge amounts of capital in developing their technology, the reality is that many still operate on legacy technology and systems. In a world where the consumer has become used to ordering an Uber or takeaway food on their smartphone, consumers have increasingly come to expect that level of ease and convenience from their financial services partners.
With this, the modern borrower is zeroing in on alternative lending solutions. Nonbank lenders are not deposit-taking institutions taking retail money, and so they are not subject to the same regulatory constraints as banks, which allows nonbank institutions to provide much more flexible financing solutions. Through this direct lender relationship, borrowers have further fueled their growth ambitions for their businesses without the need for traditional bank finance.
So at the same time as investors have been seeking investments outside the public markets, there has been a resounding demand for private credit from nonbank institutions. The match between investors seeking an alternative investment, and borrowers looking for alternative sources of credit, has merged to form the boom in private credit.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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