Direct lending, or private credit, has grown rapidly to a global market of more than $1 trillion. It is now firmly part of the mainstream for institutional investors and is attracting sizable allocations from some of the world's largest pension funds.
The relevance and appeal of private credit has grown over the last two decades (from $378 billion in 2012) as it has developed from a cottage industry to a major and sophisticated component of the market.
Today, we think the risk-adjusted return potential for private credit is the strongest in its history.
Because private lenders typically use floating rates, protection against inflationary pressures is the biggest factor drawing interest in the asset class, but it is far from the only one. The ability for private lenders to conduct in-depth diligence on borrowers and to build long-term, trust-based relationships, gives an entirely different character to comparable assets in the public markets.
These relationships often prove their worth in times of turbulence and can be a significant advantage for the speed at which managers can source, conduct due diligence and execute new investments.
Moreover, the terms of each loan can be customized to the borrower's circumstances, providing unique solutions that match their needs.
Private credit loan pricing is more certain and less susceptible to volatility than syndicated loans and junk bonds. Investors are hesitant to buy bonds as fixed-rate debt has been adversely affected by rising rates, but the floating rate feature of leveraged loans can help protect them from inflation as yields will rise along with rates.
This year, investment opportunities at a significant premium to historical averages have emerged, amid an uncertain macro backdrop.
The investment universe for private credit is also growing, as expanded pools of capital and a better understanding of the asset class are encouraging a wider range of companies to tap private credit markets for larger deals.
Investment opportunities are growing in structured and specialty asset finance and technology, along with the middle-market companies that have traditionally used private credit financing.
Attractive opportunities also are appearing in defensive sectors and cash-flow generating businesses. Private lenders are now providing complete debt solutions to larger and larger companies across sectors, an option not seen even a few years ago.
The attraction for financial sponsors and companies to engage with private lenders is clear: Private lenders can be nimble, offer certainty of execution, act with confidentiality and, most importantly, provide a long-term, trust-based relationship between borrower and lender.
This year saw syndicated bank lending markets freeze over during some periods as investors grappled with geopolitical risk, persistent inflation and rapidly rising interest rates. For private equity sponsors looking to finance new acquisitions, private credit was able to step in, offering a lifeline in a troubled market.
Recent public market volatility has only underscored private credit's appeal. The last decade of easy monetary policy was a boon for all asset classes, with a lot of return generated from asset-price inflation fueled by low borrowing costs. With rates increasing sharply, financial sponsors must now factor higher financing costs and a more uncertain economic outlook into their investment decisions.
Experienced private credit managers bring back-to-basics investing to private companies, with the resources to conduct due diligence on new investments and create value during the investment period. As the cost of capital rises and valuations adjust, fundamental value creation by investors who know a company and its management team can drive returns.
While public securities are marked daily, private market investors have the benefit of time and control. If there is trust and alignment between private equity sponsors, lenders, and portfolio companies, they are more likely to provide the right support to navigate turbulent times.
Many high-quality companies do not want the burdens of going to public markets. The illiquid nature of private investing creates advantages because they are not impacted by market technicals or day-to-day movements in their cost of capital.
More borrowers are exploring both public and private options; even the nearly $5 trillion investment-grade credit market is likely to have a large alternative private component in the future. The appeal of private credit when compared to bank-led financing stems from speed, flexibility, confidentiality, trusted partnerships and protection from inflation due to floating rates.
For private credit managers, transaction quality is critical and depends on their scale, network and ability to execute. Successful managers can leverage relationships with both financial sponsors and companies that need access to capital to build their pipeline — the best opportunities tend to come from sponsors and companies that know the track record and abilities of managers that have navigated multiple cycles in the asset class.
The need for capital remains, even as private credit is changing the way it is provided. This is creating exciting opportunities for smart institutional investors to enhance diversity, manage risk and pursue appealing returns as public markets shudder from rising rates and increased volatility.
Investing successfully in private credit usually requires working with established managers that have strong sourcing ability and risk management experience. If approached correctly, private credit can help with diversification, manage risk and bring attractive returns to pension portfolios. In our view, the strength of the asset class is set to prove its worth in the coming cycle.
Julian Salisbury is currently co-head of Goldman Sachs Asset Management and set to become CIO of Goldman Sachs Asset and Wealth Management when the two units combine at the end of this month. He is based in New York. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.
