By Dianna Carr Coletta, Managing Director & Partner, Private Credit at PGIM
Private credit has become the financial market’s favorite source of anxiety. Concerns about its rapid growth, relatively less liquid nature when compared to public credit, and a handful of high-profile corporate failures have compounded to lead some to conclude that the next systemic problem must be lurking in non-bank lending.
That concern is understandable. But it is also overdone and rests on several misconceptions. The first is that private credit is new. This is simply not true. For at least 150 years insurance companies have leant to companies through private transactions, understanding that long-dated private credit assets were a highly suitable match for their similarly long-dated liabilities. Within our company alone, we have been operating in private credit for 75 years.
Equally, direct lending, which has attracted the most criticism in recent months, is also not new. It has certainly become more popular in recent years, but the more meaningful change is the scale, investor base and the range of borrowers using it. That growth deserves scrutiny, but not alarm.
Alongside the perception that private credit is new is one that it is inherently risky. But private credit is a prosaic industry: direct lending consists of senior secured loans made to companies that need long-term capital, underwritten by lenders whose primary getting their principal back, not generating heroic upside.
More broadly, private credit is relationship lending. Teams of loan originators build networks, meet businesses before they need capital, understand local economies and underwrite companies through cycles.
This relationship approach matters most in the middle market. Many privately held businesses have historically relied on commercial banks. For them, private credit is not a replacement for banking but a complement to it: longer-term, fixed or floating-rate capital that can help finance an acquisition, shareholder transition or expansion.
These borrowers are not generally looking to maximize leverage. Many are family-owned businesses who are motivated much more by factors like resilience, control and stability.
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For some of the same reasons, these borrowers are generally more motivated to accept tighter covenants, which have a critical effect on investor outcomes.
If a company is struggling, a well-designed covenant brings the lender and borrower to the table before liquidity is exhausted and before too much enterprise value has disappeared. It can also create opportunities to reprice the asset through a higher coupon rate or additional fees, or to de-risk it through measures such as equity support, debt paydowns or new collateral. If covenants are loosened so far that a borrower runs out of cash before a breach occurs, they have failed their purpose.
This is where legitimate concern belongs. Some parts of the market have seen weaker terms, more aggressive leverage and greater use of payment-in-kind structures. Some lenders will make bad loans. Some managers will underperform. A few borrowers will fail. None of that is surprising in private credit. The appropriate conclusion is not that the whole asset class is in a bubble, but that manager selection and underwriting discipline matter more as the market matures.
Nor has the asset class been fully tested at its current scale. COVID was a shock, but extraordinary liquidity cushioned many companies. The loan vintages from 2021 to 2022, underwritten when capital was abundant and rates were lower, deserve close attention. It is in these vintages where we are seeing stress.
Defaults are indeed rising, and this is another area that deserves attention. It is worth remembering, however, that defaults were exceptionally low for much of the decade that followed the global financial crisis. In many respects, the recent increase represents a return to more normal credit conditions, and market data suggest default rates have improved from their peak last year.
Even where defaults occur, they do not necessarily translate into losses. There is a lot that can be done after a default to recover a higher value than at the time of the default.
In any case, a single troubled loan in a diversified senior secured portfolio will be diluted. Lenders have already received interest, fees and, in some cases, principal amortization. Recoveries vary, but the objective is to manage downside, not pretend credit losses never happen.
The opportunity remains substantial. In the US alone, the universe of middle-market privately held businesses is vast, and only a small fraction is private equity owned. Europe and the UK contain similar engines of employment and growth.
Across Asia, meanwhile, strong economic growth, a large middle-market funding gap and continued reliance on traditional bank financing create significant scope for private credit to expand as borrowers increasingly embrace institutional sources of capital. As these companies become more familiar with institutional capital, direct lending can provide another source of funding alongside banks and public markets.
The private credit market should not be above criticism. Transparency is critical. More careful discussion about fund liquidity, valuation practices and the links between private lenders, banks and insurers would also be helpful. But those are arguments for better analysis, not blanket alarmism.
The more useful question is not whether private credit is good or bad. It is whether capital is being provided to sound businesses on terms that properly compensate lenders for risk. Where the answer is yes, private credit is not a threat. It is part of the financial system doing what it should: channeling long-term capital to companies that need it, while giving investors an income stream that, in the case of direct lending, should be structured as senior secured and built on discipline rather than hype.
