Welcome to the latest edition of the Alternative Credit Council’s (ACC) Financing the Economy research series, produced in partnership with Dechert LLP. To mark the fifth anniversary of this research series, this year’s edition is focussed on the growth and success challenges that will define private credit over the next five years. In addition to surveying more than 60 management firms, we have enlisted the thoughts and insights of 30 leading industry individuals to support this endeavour. The survey includes managers from all corners of the world, with aggregate AuM of close to $400bn in private credit strategies. The narrative of the paper is then complemented by a synthesis of structured conversations with leading individuals whose insights you will find throughout the paper. We would like to convey our thanks to each of the firms and our interviewees for being so generous and forthright in their contributions to this research. We would also like to thank Nicholas Smith and Anton Balint, the authors of this paper, for pulling all of the pieces together in a truly remarkable manner.
At its core, private credit is about providing borrowers with growth finance, and investors with access to assets within the lending markets in the most direct manner. Substantial progress has been made by private credit managers on this front over the past ten years. Their success is evident in the way capital allocated to private credit has continued to surpass expectations.
While such progress should rightly be celebrated, private credit managers have only begun to scratch the surface of what is possible for the asset class. The expansion of the private credit universe will continue to be a key feature of the market, both from a geographic and strategic perspective. This will see managers build on their existing presence in core markets while also breaking newer ground in less developed markets. At the same time, we expect newer strategies that provide investors with access to borrowers in markets that are currently out of reach to become more prominent.
This expansion takes place at a time when questions about the sustainability of private credit become more prominent in the thinking of investors and policymakers. Are responsible lending practices being adhered to? Does private credit exacerbate pro-cyclicity in the markets or act as a useful buffer? How will the industry perform during an economic downturn? Private credit managers recognise that long-term perceptions of investors and policymakers towards the asset class are extremely important. Rather than shying away from such challenges, many managers have put them at the forefront of their thinking when building their businesses and investing in their operating infrastructure.
Inevitable challenges lie ahead for private credit. Risks continue to build up in many credit markets, and the resilience of business models will be tested over the next five years in different ways. The success of the asset class during this period will come from private credit managers continuing to be a valuable and trusted partner to their borrowers and investors in good and bad times. This research showcases how private credit managers are preparing to meet this challenge and ensure their stakeholders continue to prosper, whatever the economic weather.
Global Head, Alternative Credit Council
Partner, Financial Services, Dechert LLP
Drivers of long-term structural growth are intact: The factors supporting the growth of private credit – increasing attraction of private markets to investors, retrenchment of the banking sector and the appeal of direct lender relationships to borrowers – will fuel further expansion of the asset class over the next decade. Capital allocations to the asset class will be driven by private credit managers’ ability to offer differentiated growth and income opportunities, especially in a low-yield environment, as well as the potential downside protection in times of market turbulence. This will see a greater diversity of markets and strategies evolve within the broader private credit label. The market is likely to increasingly differentiate between private credit managers focussed on niche markets and those who can provide investors with access to multiple private credit strategies.
Cyclical concerns are top of the agenda: The credit and economic cycle is a primary consideration for nearly all private credit managers, influencing their approach to underwriting practices, and the way they price risk and structure deals. Capacity to deal with stressed loans is now a key point of differentiation for investors when assessing private credit managers, as they look to identify managers with resilient business models. When it comes to human capital, the industry is experiencing a growing demand for skilled individuals and continues to compete with the private equity world for skilled labour.
Harvesting the complexity premium is key: Flexibility towards their client’s needs remains a recognised strength of private credit, but one which comes at a price in the form of ever-increasing demands on operational infrastructure. The unique regulatory barriers faced by private credit managers in some markets continues to be the single biggest determinant of growth for private credit in those jurisdictions. Private credit managers are addressing this by investing heavily in staff with the necessary skills and experience, introducing greater efficiencies into the lending process with the help of new technology and engaging with policymakers to reduce regulatory barriers.
Institutional capital pulls parts of the market towards homogenisation: Private credit has always been an institutional asset class and the influence of institutional investors will continue to have a significant bearing on its development. Their expectations around risk management, portfolio monitoring and reporting are already driving investment by private credit managers in their operating infrastructure, and we expect this trend to continue. The acceptance of private credit by institutional investors who have not yet allocated capital to private credit is likely to be accelerated by the development of more sophisticated data sources and recognised performance benchmarks. Prudentially regulated investors continue to push for harmonised risk metrics and ratings, which can sometimes conflict with the bespoke and idiosyncratic nature of private credit assets.
ESG considerations shaping the market: A structural shift in the attitudes of investors towards ESG considerations in private credit has taken place. Inconsistency in how ESG elements are reflected in investment choices and the absence of standardised data formats is hindering the incorporation of ESG into broad market practices. However, the industry continues in its effort to establish a consensus on what constitutes relevant ESG metrics or approaches and support investors’ understanding and demands. Private credit managers are also making a corresponding investment in their own systems to capture, monitor and report relevant data. Meanwhile, diversity is increasingly recognised as a business development (attraction of talent) and competency issue, including as a safeguard against the risk of groupthink.
Transparency is key to sustainability: The need for the industry to support investor and policymaker understanding of private credit remains paramount. Establishing better sources of market data and appropriate performance and risk metrics is just one way the market will demonstrate the value of private credit to these stakeholders. It will be essential for private credit managers to support an evidence-led policy approach to the sector at a time when concerns around late cycle dynamics increasingly colour perceptions of the market. The challenge for private credit will be to reframe this conversation to one about private credit stimulating economic expansion and delivering value to its investors.
The retrenchment of the banking sector, the increasing importance of private markets for investors, and the enduring appeal of a direct lender relationship for borrowers are among the key structural factors underpinning the continued expansion of private credit. These tailwinds are here to stay, allowing private credit managers to develop new products, strategies and markets for their investors.
These structural factors are likely to be tempered by what one of our interviewees called the “the most talked-about and anticipated turn of the credit cycle in history”. How the industry navigates this challenge in some of its most mature markets will be important for the future of the asset class.
While some think we will experience a ‘make or break’ moment in the next few years, most feel that the model is sound enough and well established to weather any storm. The latter view doesn’t translate to a naive optimism, but a recognition that private credit has an important role in the financing mix of the economy in any future state of the world.
The ACC’s Financing the Economy research series has been central to the dialogue and collaboration between managers and their key stakeholders – borrowers, investors and policymakers. It highlights the need for a continued improvement in disseminating data and educational materials to improve the understanding of our rapidly developing market. The continued support of this collective effort will ensure the sector’s sustainable future.
Financing the Economy - The future of private credit is available to members and non-members of the ACC and AIMA. For more information about the report, feel free to contact authors Nicholas Smith and Anton Balint, at email@example.com and firstname.lastname@example.org respectively.
A double-page spread version of the report is also available here.