In recent years, private credit has emerged as an important financing source for corporations of all kinds, especially for private equity-owned businesses with high financial leverage. The growth of private credit can be traced back to the Great Financial Crisis of 2008-2009. Following the GFC, the government enacted new regulations that limited banks’ abilities to underwrite highly leveraged financing. In particular, new guidelines from the FDIC and Federal Reserve (among other governmental agencies) made it more difficult for banks to underwrite financings that resulted in debt-to-EBITDA ratios in excess of 6.0x. Over time, private credit providers with greater financial flexibility stepped in to fill the void left by the banks’ retreat.
To understand the growth of private credit, you must first understand more traditional leveraged finance, which involves broadly syndicated deals. Under this structure, banks typically provide committed financing to buyers (in this case, often private equity firms). This means that banks commit to providing debt financing for a transaction, and then they syndicate this debt out to a variety of investors and pocket a fee for this service (say, 2-3% on average). The buyer universe for this debt most often includes collateralized loan obligation (“CLO”) funds, high-yield mutual funds, insurance companies, and other similar institutional buyers. This committed financing is essential for a private equity buyer because buyers must include certain funds in their acquisition offers; if they were to make acquisition offers that were contingent on receiving uncertain debt financing, their offers would be much less competitive, and it would thus be more difficult for them to win competitive auction processes for the most desirable acquisition targets.
However, this business can be risky for banks. They must take a capital charge against the capital reserve for this commitment (a charge that has generally increased over time to incentivize banks against risk-taking). This capital is released once investors buy the debt off the banks’ balance sheets. But if banks are unable to fully syndicate this debt, they are stuck holding debt that they do not want (this is called a hung deal). They must then go out and offer the debt to investors on more attractive terms than what they guaranteed to the private equity sponsors and they are left taking a loss on any difference between these prices. This is a very bad scenario for bankers whose business model is contingent on moving commitments (called going off-risk) as fast as possible.
Private credit firms operate in a very different manner. Rather than providing debt financing with the intention of selling exposure to other parties and collecting a fee, private credit firms aim to provide all of this financing themselves and hold the debt until maturity. Economics is generated by the fees, principal, and interest payments made by the borrower rather than the commitment fees earned by the banks. As such, private credit firms can be thought of more as long-term partners who are truly invested in the success of the borrower.
This has a number of implications. First, the private credit investor must do much more rigorous diligence than a bank might do. This includes an analysis of all manner of the company’s operations and financial condition, among many other factors. This is because the private credit investor will retain financial exposure to the borrower for as many as five to seven years, compared to a period of weeks or months for a bank. Second, private credit investors are able to provide substantially more flexibility for borrowers. Think about it this way: It is easier to negotiate bespoke partners via bilateral negotiation with a single partner than with tens of investors via a syndicate of investment banking middlemen. Private credit investors are also generally able to act with greater speed and certainty. Compared to a syndicate of banks, each with different teams for industry coverage, leveraged finance, syndicate, credit committees, etc., private credit firms typically operate with a single investment committee that can make decisions in a more nimble manner.
This may lead you to ask, Why ever use a broadly syndicated solution when private credit exists? There are two main reasons: pricing and covenants. Private credit is typically a more expensive source of capital, with investors charging a higher rate of return in exchange for all of the advantages laid out above. This may come in the form of higher interest rates, more aggressive amortization schedules, required equity co-investment rights, or other forms. On the covenant front, private credit investors often require more stringent covenants that require borrowers to maintain certain predetermined leverage levels or liquidity requirements (just two examples). By comparison, the broadly syndicated market of the past few years has had little or no covenant requirements (loans known as cov-lite).
What impact has this had on private equity? To start, this has made financing markets more competitive. Given that private credit and broadly syndicated solutions are effectively in competition with each other, both financing sources must constantly work to provide the best terms they can (while of course meeting their own internal risk/return requirements) in order to win business. Second, private credit has emerged as a way for firms to continue doing deals when there are adverse macro or market conditions that limit the availability of syndicated financings. For example, banks suffered from numerous hung deals in the 2021-2022 timeframe (Citrix, Twitter, and many others), which limited the flexibility banks had to underwrite new financings. During this time, deal activity remained limited, but private credit emerged to finance a smaller number of new deals.
With interest rates remaining high and borrowing conditions challenging, private credit has also proven to be a reliable way to refinance highly leveraged businesses. For example, just recently, a group of private credit funds provided a loan of over $5 billion to help refinance the capital structure of Finastra, a portfolio company of private equity firm Vista Partners. With many private equity-backed companies facing near-term maturities that may be difficult to refinance, we might expect many more deals of this type in the near future.
When companies with traded debt enter distressed territory, CLOs often sell their holdings to distressed investors with significant experience negotiating bankruptcies and other restructurings. However, with so many companies now backed by private credit, a new question has emerged. Since there is no real market for trading private loans, how will private credit firms handle the likely onslaught of distressed companies? While they may have internal workout capabilities, it is unlikely that these teams are prepared for the number and extent of bankruptcies in the same way that traditional distressed investors might handle the traded secondary market. This means that there will likely be new market mechanisms or trading vehicles that emerge for private credit investors to sell or otherwise unload the risk associated with private credit loans gone bad. It is unclear at this time how this will all unfold, but as always, it will be important for private equity firms to understand these changing dynamics and manage their portfolio companies’ financing with a prudent eye.
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