Private Credit’s Rise Continues—But Not Because of SVB

Private credit—also known as direct lending or private debt—has seen a meteoric rise since the financial crisis. And its rise isn’t over: In its 2023 report on private debt, Preqin projected that global private debt assets will reach $2.3 trillion by 2027—an assertion supported by the investors they surveyed, 63% of whom said they intend to increase their private credit allocations in the long term.

The stratospheric climb of private credit has been driven in part by sponsored middle-market direct lending, which as of the second quarter of 2022 was up 41% year over year, coinciding with a rise in leveraged buyouts in the middle market, according to Refinitiv data. In many ways, private credit has become synonymous with middle market lending. “Obviously, banks are still an option for some, but clearly the majority of new deal flow from the core middle market during the past year is coming to the private credit market,” says Blair Faulstich, managing director with asset management firm Benefit Street Partners, which works primarily with companies with $30-75 million EBITDA.

But a complex macroeconomic environment sends mixed signals for private credit’s near future in middle-market dealmaking. While a slump in M&A and rising interest rates could keep traditional buyout financings low in the near term, and regional bank failures and bankruptcies haven’t created the expected tailwinds, leaders in the sector say that nascent retail investor interest and add-on acquisitions are driving demand for the sector.

Twin Headwinds Create Challenges

Two headwinds challenging private credit are the swift rise in interest rates, now at a 22-year high, and weak M&A activity throughout the first half of 2023. The second quarter saw just 3,828 deals closed in North America in Q2, down 30.4% from the same period in 2022, S&P Global Market Intelligence reports. Transaction value is down even further. But direct lenders say that add-on deals have kept them active.

“There has been a slowdown in transaction volume, no question, and that’s driven principally by the rapid rise in rates, which has caused a gap in valuation expectations among buyers and sellers of businesses,” says Brent Humphries, president of AB Private Credit Investors, Alliance Bernstein’s private credit arm, with roughly $2 billion dollars of funded exposure in almost 200 companies. He notes that while true M&A transactions are rarer than in previous years, his fund continues to grow their portfolio via growth financing and tuck-in acquisitions—and expect transaction volume to recover as the valuation gap is reduced over time.

“I can’t speak for everyone, but we’ve seen continued interest in add-on activity,” Michael Ewald, the global head of the private credit group at Bain Capital Credit, which focuses on companies in the core mid-market with $25-75 million EBITDA, agrees. “In a typical year it’s around 80% new platform activity, 20% add-ons, and right now it’s probably 50%, 50%, so that’s definitely been a change in the market.”

The rising rate environment will also keep the appetite for refinancing low, says Faulstich, but there’s hope that a clearer economic outlook will kick demand back into high gear. “If you’re driving a car in a storm, what do you do? You pump the brakes,” Faulstich says. “Once the storm passes, financial sponsors and management teams will step on the accelerator again. Once we can see what’s ahead, things will pick back up again.”

Once the storm passes, financial sponsors and management teams will step on the accelerator again. Once we can see what’s ahead, things will pick back up again.

Blair Faulstich

Benefit Street Partners

The SVB Bump That Never Materialized

Private credit first appeared as a major player in the middle market after the great financial crisis, when traditional banks took a step back from middle-market lending due to new regulations and capital requirements. The failure of Silicon Valley Bank (SVB) and two other regional banks earlier this year seemed to signal a similar opportunity for private credit to step in and fill the gap left by retreating traditional lenders.

Faulstich, however, says that this moment won’t serve as a game changer anywhere near the same level as the financial crisis. “I don’t really think that’s a demand driver,” he says. “There are 4,000 community and regional banks in this country that serve as an important part of the ecosystem for lending and growth capital. But if you look at their loan books, they’re typically doing pretty small deals for small companies. There are people out there talking about maybe raising smaller funds to capture that smaller part of the market, but not many.”

Related content: After SVB: How the Banking Sector Is Impacting M&A

Ewald and Humphries agree that regional bank weaknesses have not proved to be a growth driver for private credit.

“When liquidity in the market is scarce and banks are more risk-averse, that’s generally good for private credit. We thought some of the challenges that SVB and other regional banks faced would be a real benefit to us. I’ll say candidly, it’s probably been a little more overblown than what’s actually occurred,” says Humphries.

We thought some of the challenges that SVB and other regional banks faced would be a real benefit to us. I’ll say candidly, it’s probably been a little more overblown than what’s actually occurred.

Brent Humphries

AB Private Credit Investors

While 2023’s bank failures may not fundamentally change the dynamics of private credit going forward, that doesn’t mean they’re not bringing new opportunities in the short-term. Faulstich says that private credit firms will likely see prospects to buy loan portfolios from community and regional banks, and indeed, that opportunity is already materializing. Bloomberg reports that U.S. regional banks are offering their consumer loans to private credit firms—though many investors are waiting for a better price before they buy.

The Moment for Distressed Debt

Distressed debt, a subset of private credit that focuses on restructuring companies that are struggling financially, has not seen the same steady rise as private credit over the years. After hitting record heights in 2020 and 2021, distressed debt fundraising slumped in 2022, according to data from Preqin. But there are signs that distressed debt could be on its way back up: Recent research found that 35% of North American LPs are planning to invest in distressed debt over the next year.

These investors may have foreseen the rising number of companies in financial distress. Epiq Bankruptcy reported that U.S. Chapter 11 bankruptcy filings have increased by 68% in the first half of 2023 compared to the same period in 2022.

Related content: Preparing PE Sponsors and Private Credit Lenders for a Potential Bankruptcy Wave

However, the rising number of troubled companies can present some challenges for distressed debt investors. “The market’s not pricing in the cost and complexity of bankruptcy, so we’re eating that [cost],” says Ray Costa, a managing director at Benefit Street Partners. “The game has become very multidimensional in terms of the risk, so as an investor, we have to think about our opportunity set much differently than just bankruptcies.”

But the current unforgiving economic environment will certainly continue to provide distressed lenders with opportunities outside of bankruptcies. “I’ve always thought of distressed debt as a capture-the-discount model,” Costa adds. “Simple problems, simple clean-ups, betting on cycles, recovering. Personally, I think the opportunity set is going to grow.”

What’s Around the Corner?

If some of the expected tailwinds for private credit have proved less powerful than expected, it hasn’t done much to temper the rise of the sector. Bloomberg reported that 34 new funds raised $71.2 billion in the second quarter of 2023, among them Comvest Partners’ $2 billion fund and Proterra Investment Partners’ $500 million fund.

Humphries says that there continues to be significant opportunity for growth in private credit, pointing to retail investors as the next frontier from a capacity perspective. “While there’s still good demand among institutional investors—and they have actively allocated to this space over the last handful of years—the retail investor is still underexposed to alternatives in general and private credit specifically,” he says. “I think you’ll start to see more offerings and products like the public, non-traded BDCs targeting the retail investor. I also expect strong borrower demand as larger companies increasingly prefer to source financing via private credit managers compared to the broadly syndicated and tradeable loan market. So, I believe there is significant runway and growth opportunity in our market.”

Ewald agrees, adding interval funds, wirehouse platforms, and RIAs to the list of private credit products that are targeting these investors: “You’re getting a lot more access to the retail investor, and there’s additional capital available there.”

There’s also the knowledge that M&A won’t remain depressed forever—and when it rebounds, private credit will be ready and waiting. “There’s this massive log jam that’s building right now,” Faulstich says. “So when CEOs and CFOs and boards start to feel more confident in the economy, the M&A market is going to be very active.”

He compares the current backlog of M&A deals with the COVID-era pause: “The market was shut down for April, May, June, July, August, and then boom, in the fourth quarter of 2020 the M&A market boomed. Well, this log jam’s even bigger, but when it opens up is anyone’s guess.”

Hilary Collins is ACG’s Associate Editor.

Middle Market Growth is produced by the Association for Corporate Growth. To learn more about the organization and how to become a member, visit www.acg.org.