Despite rapid development, private credit is still in its very early growth stages. Despite macroeconomic and cyclical challenges, Jiři Król, the deputy CEO of the Alternative Investment Management Association, sees private credit catching up to the much larger private equity in the next 10 years. He also sees huge potential development from the reformed European long-term investment fund vehicle (Eltif).
“My sense is that private credit will eclipse private equity in the next decade,” Król told Investment Officer. “It has a much broader addressable market.”
He added that private credit providers are already lending to private equity-owned companies. The industry got its start with private firms offering financing after banks significantly withdrew from doing so after the 2008 crisis.
Early stages
“I think we’re in the very, very early stages of private credit growth,” said Król. “It moved from a sort of a mid-market product to… a full financing vertical for the very largest corporates today.”
He also points to two important areas of growth. He said he sees that asset-backed lending “could be a 7 trillion dollar market in the next three years.” He explained that this includes aircraft leases, train leases, trade, finance, commodity finance and real estate lending.
On top of this “people are moving into the investment grades, what some people call a fixed income replacement market.” He said some observers estimate this “opportunity” to be around 44 trillion dollars.
Potential threats
Some observers, including Klaas Knot, president of the Dutch central bank, and David Miller, the head of global private credit & equity at Morgan Stanley Investment Management, have pointed to potential threats to private credit. Knot pointed out that 56 percent of Dutch companies’ debt is up for refinancing in the next two years.
Miller, who’s generally positive on private credit, warned that with expected increased rates of default and banks returning to underwriting leveraged credit deals, their environment has become more challenging than just a year ago.
Król underlined the importance of differentiating between the “broadly-syndicated market” and direct lending, “the pure private credit market where banks do not act as intermediaries and as underwriters.”
Filling the gap
He then explained that last year, “banks have very much slowed their activity in the broadly syndicated market. And the private credit markets started to fill the gap instead.”
He moved to what Miller’s warning. “Now the banks have come back a little bit.” But, he emphasised, “it was always a space where the banks were playing”.
“So we don’t see that as something which is anomalous or strange, in that we feel that the more liquid markets, the more public markets are going to be a bit more cyclical than purely private markets.”
Król acknowledged that defaults are rising. “We do not expect managers to be surprised by it in the private credit space”. He explained that this is because of their heavy use of covenants.
“The direct lending market uses covenants that allow the direct lenders to intervene when those covenants are breached,” he explained.
Luxembourg great start
Luxembourg is sitting very pretty when it comes to private credit, Król explained. “Luxembourg had a great start to private credit in that it was already a strong private market jurisdiction for funds and fund managers,” he said.
He continued to sing Luxembourg’s praises. “Unlike other jurisdictions, Luxembourg didn’t start putting some restrictive measures on loan-originating funds. I think that was a huge mistake made by Ireland back in the day.”
With the arrival of AIFMD II “some of that regulation will trickle down” and place “tighter rules on loan origination.
Grain of the market
“One of the things Luxembourg can do is to implement those rules with the grain of the market and really trying to make sure they remain as flexible with the directive’s framework.”
Król had great praise for Luxembourg’s reserved alternative investment fund vehicle, the Raif.
“Raif is a vehicle of choice for credit managers. It works from a regulatory perspective, it works from a tax perspective, it’s light touch, It’s easy to launch, time to market is quick.”
Król also sees huge growth potential for private credit in the attempts by Europe and the UK to give retail investors access to private assets through, respectively, the Eltif and the Ltaf vehicles. He pointed to the huge success of the US business development company vehicle. He said the valuation of BDCs had increased from 50 billion dollars at the outset to over 300 billion dollars now.
“We’ve just recently had a reform of the Eltif which would hopefully bring it to par, if not even to a better place than the US business development company. We think that the retail market is going to be another big source of investment for private credit managers.”