The Economist - USA (2022-02-26)

The Economist February 26th 2022 SpecialreportPrivatemarkets 9

Private credit

Sons of Drexel

A

s he ascendedthe hierarchy of corporatefinanceinthe1980s
to become king of junk bonds, MichaelMilkenstoodout.Not
least  physically:  he  paced  the  trading  floorofDrexelBurnham
Lambert sporting a lush but ill­fitting wig.Morethan 30 yearson,
junk bonds are a recognised part of the marketforraisingcapital.
So are other innovations spawned by the buy­outbarons,suchas
collateralised loan obligations (clos), securitiesintowhichlever­
aged loans are packaged. Fast gaining groundonthesedebtmar­
kets is one for private credit, which may nowbecausingmoreex­
citement than any other private market.
Before the financial crisis, private creditwasa nichepursuit,
consisting  of  distressed  debt  and  “mezzanine”finance(arisky
segment  between  debt  and  equity).  Overthepastdecadeithas
spread  to  activities  ranging  from  aircraft  leasingto“directlend­
ing”,  or  loans  to  small  and  mid­size  companieswithoutusinga
bank or securities firm. pefirms are cuttingoutbanksandborrow­
ing  from  direct  lenders,  including  each  other’screditarms,to
fund buy­outs. Banks huff at this looseningoftheirgriponfinanc­
ing pedeals that used to be backed by theirloansorjunkbonds.
The private­credit market has more thandoubledinsizesince
2015  and  is  now  worth  at  least  $1trn  worldwide,notfaroffthe
$1.3trn institutional loan market, says Moody’s.Thebisreckonsit
may  be  closer  to  $1.5trn.  Private  credit  hasattimesrecentlyex­
ceeded junk­bond issuance, itself at recordlevels.Transactionsiz­
es have risen commensurately. “Fifteen yearsagothebiggestdeals
were a few hundred million dollars. Now they’refourorfivebil­
lion,” says Michael Arougheti, boss of AresManagement.
Ares is one of several firms dominatingthemarket.Othersin­
clude  Apollo,  Blackstone  and  Brookfield.Aressoughttoraisea
$4.5bn credit fund last year. So strong was demandthatit closedat
$8bn. Debt specialists are among the privatemarkets’hottestas­
sets. Brookfield bagged one of the most sought­afterin2019,pay­
ing  $4.7bn  for  a  majority  stake  in  OaktreeCapital.Mainstream
fund  managers  are  also  gaining  a  foothold:creditaccountsfor
around half of BlackRock’s $320bn alternativesbusiness.
The market has been propelled by two bigforces.Oneisthere­
treat  of  banks,  leaving  a  void  for  non­
banks.  This  began  in  the  2000s  as  banks
looked to trim inventory and go back to be­
ing  agents,  not  principals.  It  accelerated
after  the  financial  crisis  as  banks  were
forced  by  tougher  capital  requirements  to
offload risky assets. The second is the ubiq­
uitous search for yield. Private credit offers
juicier  returns  than  mainstream  fixed  in­
come. Rock­bottom rates have “pushed ev­
er more investors into a liquidity­for­yield
exchange”, says Jean­Marc Chapus, the co­
founder of Crescent Capital.
In  America,  banks’  share  of  lending  to
small  and  mid­size  firms  has  fallen  from
around  30%  to  20%  since  2010,  reckons
Moody’s. Banks have also backed off prop­
erty lending, particularly for construction
and  refurbishment,  for  which  regulated

lendershavebeenhitwithsteepcapitalcharges.Spurredbyac­

countingchanges,banksacrossEuropehavemarkeddowndud

propertyloans.Private­debtfundsaresnappingtheseupat50­60

centsontheeuro,rewritingloancovenantsand,wherenecessary,

offeringborrowersfreshliquidity,saysStuartFiertzofCheyne

Capital,analternativeassetmanager.

Theyhavealsobeenbusyinmarketsthatemergedfromthe

wreckageofthesecuritisationmeltdownof2008,conjuringdeals

forspeciality­financecompaniesinequipmentleasing,consumer

lendingandreceivablesfinancing.Apollohasboughttwocar­

leasingfirms,a providerofhome­improvementloansanda com­

mercial­mortgagelenderwitha clean­energyfocus.

Private credit gives investors more options in themiddle

groundofrisk,betweenstaidbondsorsyndicateddebtandracy

privateorgrowthequity.Expectedannualreturnsrangefrom4%

tothelowteens,dependingontheproduct.Bothfeesandtherisk

ofaninvestmentfloppingarelowerthanwithbuy­outs.Investors

withexplicitreturntargets,suchaspensionfunds,areunder­

standablytemptedbycouponsof8­10%ormore.ScottKleinman,

co­president of Apollo, says such long­

termcapitalisa goodfitforprivatecredit.

“Itellthemthey’rethelong­termlenders

ofthefuture.”

Forborrowers,theattractionisavail­

ability:smallercompaniescan’teasilyac­

cesspublic orsyndicated debtmarkets.

Others valuenegotiatingcontractsmore

closelytailoredtotheirneedsthanispos­

sibleinothermarkets,orthefactthatdi­

rectlenderscanmovequicklyandalsobe

moreforgivingofdefaults.Someborrow­

ersusethemarkettoavoiddisclosurere­

quiredinpublicdebtmarkets.Forcredit

funds,anattractionisthepromiseofex­

cessreturnforilliquidityor,asMarcRow­

an,Apollo’sboss,putsit,“complexityand

origination”.Ata bigenoughscale,making

a spreadofa singlepercentagepointover

Asset managers rush in where banks feartotread,
transforming a formerly niche market

Creditable performance

United States, private credit

Source:BankforInternationalSettlements

50

40

30

20

10

0

2015102005

As%ofannual

leveragedloans

200

150

100

50

0

2015102005

As % of annual high-

yield corporate bonds