Originally published in The Financial Times
If this is a “golden moment” for private credit, how might it play out and what are the risks?
Higher rates and the regional banking turmoil earlier this year have spurred a growing conviction that private credit will bloom. The market is expected to grow from $1.6tn this year to $2.8tn, according to data provider Preqin. BlackRock is even more optimistic, forecasting growth to $3.2tn.
“Debanking” is at its early infancy, argues Marc Rowan, chief executive of private capital firm Apollo. And Jon Gray, president of Blackstone, coined the “golden moment” description of conditions in private capital early this year.
Take new bank regulations as a catalyst: under the proposed Federal Reserve rules, the capital required to support the US wholesale banking industry could increase by as much as 35%, according to Oliver Wyman. Little wonder that Jamie Dimon said private credit providers will be “dancing in the street”.
How the market develops will be a pivotal issue not just for the large private market firms and banks – but also for the traditional asset managers, which have been bolting on private market capabilities to fend off the inexorable rise of passive fund management. At least 26 traditional asset managers have bought or launched new private credit units in the past two years.
This shift underscores just how much the market structure of finance is changing. Twenty years ago I argued in a Morgan Stanley research note that investor flows would polarise into a barbell. At one end, investors would flock to passive and exchange-traded funds to access benchmark returns cheaply and conveniently. At the other, investors seeking higher returns would increasingly allocate to specialist fund managers investing in private assets, hedge funds and real estate.
The conventional “core” fund managers, caught in the middle, would be pressured to tune up their investment engines, become more specialised, or merge for scale. And so it has turned out.
ETFs have grown from $218bn in 2003 to $10.3tn last month, according to ETFGI. And in revenue terms, it is striking quite how lopsided it has become. Half of all the management fees in the investment industry are likely to go to alternative asset managers in 2023, up from 28% in 2003.
Central bank quantitative easing to support economies and markets, which buoyed the earnings of traditional firms, is now being wound down. Without that tailwind, the squeeze on asset managers is becoming ever more acute. So how will the moves into private credit play out?
Today just 10 firms account for 40% of private credit fundraising in the last 24 months, according to Preqin. There are three reasons why the growth in private credit could disproportionately play to the hands of these larger firms.
First, a good amount of the growth is likely to come from portfolio sales by regional banks that need to deleverage, often selling good assets under duress. New Fed rules means larger banks simply won’t be able to pick up the slack. Buying these assets is a specialist endeavour with big portfolio sizes and the speed required for deals playing to the advantage of the scaled firms that can underwrite the risks.
Second, the growing size of deals calls for larger funds; this August saw a fresh record for the largest loan at $4.8bn for fintech firm Finastra.
Third, and critically, banks want to partner up so they don’t lose access to the clients. Whilst tougher regulations means they likely to need to shed assets, banks will want to continue to make loans and partner up to help manage the deal flow, again benefiting those firms with scale. Several major banks have already cut deals, and more are likely to follow. Citi is the latest to be reportedly launching a new unit in 2024.
The regime shift in rates means loan losses are likely to rise as financing costs normalize and weaker balance sheets are exposed. This could be challenging for private credit providers. New firms trying to muscle in on the growth may not be as prudent. This calls for selectivity and keen focus on the risks and returns in deals – but also for teams experienced in workouts, which many majors have.
Of course, there will be specialist seams of opportunity, such as distressed debt or energy infrastructure lending, where a talented boutique can have advantages. But this may not be at the scale needed to boost the traditional firms’ fortunes.
There is a sea change coming in capital allocation that calls for a shift towards private credit, as Howard Marks recently argued. But these rising waters won’t lift all boats.