Private credit is an asset defined by non-bank lending where the debt is not issued or traded on the public markets. Private credit can also be referred to as "direct lending" or "private lending". It is a subset of "alternative credit". Private Credit has been one of the fastest-growing asset classes. Just in 2017, private debt fundraising exceeded $100B. One factor for the rapid growth has been investor demand. Returns have averaged 8.1% IRR across all private credit strategies, and some strategies have yielded as high as 14% IRR. At the same time, supply has increased as companies have turned to non-bank lenders after the financial crisis due to stricter lending requirements. As of the start of Q4, 2019, there were 417 private credit funds seeking to $177B. The vast majority of the capital was directed to direct lending with mezzanine debt as a distant second. However, there was fund raising for other strategies including distressed debt, venture debt, and special opportunities. In terms of capital raised, Europe is currently outpacing North America. In Q3, 2019, $6.5B was raised for North American funds compared to $13.9B for Europe. Asia came in a distant third with $1.5B raised. One recent trend has been the rise of covenant-lite loans. This has been driven by investor demand for the relatively high yield compared to alternatives and a willingness to accept less protections. This has resulted in fewer company restrictions and fewer investors right if the company struggles. That being said, for the investment firms, covenant-lite loans can also be helpful because of the negative optics if a portfolio company goes into default, and fewer restrictions means fewer ways a company can go into default.
Role of BDCs
In addition to private funds, much of the capital for private debt comes from business development companies. BDCs were created by Congress in 1980 as closed-end funds regulated under the Investment Company Act of 1940 to provide small and growing companies access to capital and to enable private equity funds to access public capital markets. Under the legislation, a BDC must invest at least 70% of its assets in nonpublic US companies with market value less than $250M. Moreover, like REITs, as long as 90% or more of the BDC’s income was distributed to investors, the BDC would not be taxed at the corporate level. While BDCs are allowed to invest anywhere in the capital structure, the vast majority of the investment has been debt because BDCs typically lever their equity with debt, and fixed income investing supports their debt obligations.
Over 70% of the investor capital for private credit comes from institutional investors. For non-institutional investors looking to invest in private capital, few options exist because most of the investment vehicles are private and limited to qualified investors. That being said, investors can invest in publicly-traded BDCs and closed end fund focused on private credit. The only Exchange-traded fund in the asset class is the Virtus Private Credit Strategy ETF, which an index ETF of BDCs and publicly traded closed-end funds focused on private credit.
