Morgan Stanley
  • Investment Management
  • October 25, 2023

Understanding Private Credit

Private credit, which can offer floating interest rates that increase in tandem with benchmark rates, has seen significant growth in recent years and could become a US$2.3 trillion market by 2027.

Demand for private credit—which refers to lending to companies by institutions other than banks—has grown significantly in recent years. Unlike most bank loans, private credit solutions can be tailored to meet borrowers’ needs in terms of size, type or timing of transactions. Similar to bank loans, however, the majority of private credit lending is in the form of floating-rate investments that change as rates change, providing real-time interest rate protection compared to investments like fixed-rate bonds.

In addition, amid recession fears and constrained commercial bank lending, which traditionally leads to credit tightness, private credit offers borrowers pricing certainty and speed, which has helped fuel the market’s growth in recent years. The size of the private credit market at the start of 2023 was approximately US$1.4 trillion,1 compared to US$875 billion in 2020, and is estimated to grow to US$2.3 trillion by 2027.2

Ashwin Krishnan, Co-Head of North America Private Credit at Morgan Stanley Investment Management, explains the different types of private credit, the growing appetite for the asset class and how private credit has behaved in prior market cycles.

Q: What is private credit and what are the different types?

Krishnan: Private credit is a form of lending outside of the traditional banking system, in which lenders work directly with borrowers to negotiate and originate privately held loans that are not traded in public markets. Following the Global Financial Crisis (GFC) in 2008, and the associated capital rules for banks, private credit has filled a lending void.

There are generally four common types of private credit:3

  • Direct Lending: Direct lending strategies provide credit primarily to private, non-investment-grade companies. Direct lending strategies may be appealing as they invest in the senior-most part of a company’s capital structure, which may provide steady current income with relatively lower risk.
  • Mezzanine, Second Lien Debt and Preferred Equity: These three forms of credit, collectively known as “junior capital,” provide borrowers with subordinated debt. This kind of instrument is not secured by assets and ranks below more senior loans for repayment in the event of a default or bankruptcy. Junior capital often comes with equity “kickers,” which are incentives that can support attractive total returns—often on par with equities—while still being a debt claim in the payment waterfall. 
  • Distressed Debt: When companies enter financial distress, they work with existing distressed debt investors to improve their prospects through operational turnarounds and balance sheet restructuring. Distressed debt is highly specialised and the prevalence of opportunities tends to coincide with economic downturns and periods of credit tightness. These lenders take on a higher level of risk in exchange for lower prices and potentially high returns.
  • Special Situations: Special situations can mean any variety of non-traditional corporate event that requires a high degree of customization and complexity. This may include companies undergoing M&A transactions or other capital events, divestitures or spinoffs, or similar situations that are driving their borrowing needs.

Q: What is the role of private credit in a portfolio?

Krishnan: Investors have increasingly added private credit to their portfolios as a potentially higher-yielding alternative to traditional fixed-income strategies. It can potentially include the following:

  • Current income: Like traditional fixed income, private credit generally offers the possibility for current income from contractual cash flows (i.e., interest payments and fees).
  • Illiquidity premium: Private credit may provide a yield spread above public corporate bonds to compensate for the “illiquid” or non-tradeable nature of the investments.
  • Historically lower loss rates: Private credit has demonstrated lower default rates relative to public credit over time.
  • Diversification: Private credit has been less correlated with public markets than other asset classes, such as equities and bonds. This can help reduce portfolio volatility and improve risk-adjusted returns.
  • Customised portfolio construction: It may be possible to create highly customised portfolios of strategies to blend risk-adjusted returns across a variety of private-credit strategies.

Q: How have returns for private credit compared to those of traditional fixed-income investments?

Krishnan: Private credit has historically offered compelling performance in relation to other segments of the fixed-income market. Since the global financial crisis, when private credit began growing in earnest, direct lending (the most common type of private credit) has provided higher returns and lower volatility compared to both leveraged loans and high-yield bonds.4,5


High Returns Relative to Volatility 4,5

Direct Lending's Outperformance in High Interest Rate Environments 4,6

*Past performance is not indicative of future performance

Private credit may also offer better protection against losses, having demonstrated relative resiliency during the COVID-19 pandemic. Between the outbreak of COVID and the second quarter of 2022, direct lending sustained losses of 1.2%, compared with losses of 1.4% for leveraged loans and 2.7% for high-yield bonds.4,7

Direct Lending's Fewer Losses During COVID-19 4,7

*Past performance is not indicative of future performance

Q: Where do you see opportunities in the private credit market?

Krishnan: We see the potential for opportunities in the following areas:

  1. Refinancing the upcoming “maturity wall” of leveraged loans and high-yield bonds issued around the same time, which are now approaching their repayment dates. We expect to see issuers increasingly turning to the private credit market for refinancing solutions.
  2. Investing in private equity sponsors, who will continue to be the primary drivers of private credit consumption, given their significant capital available
  3. Given the marked increase in base rates over the last 18 months, we expect companies to explore junior capital solutions to manage interest expenses and boost cash flow.
  4. Rescue-financing capital, should the economy enter into a recession or high-default environment.

Q: What are the key considerations for private debt in a difficult macroeconomic environment?

Krishnan: We believe that a highly proactive approach has become increasingly important, which includes closely analysing companies’ earnings and free cash-flow generation in light of the current economic and interest-rate environment.

Meanwhile, for companies, the primary focus is liquidity management. Borrowing costs have increased significantly over the last 18 months, as loans are a floating-rate product. To date, the vast majority of borrowers in the market have been able to successfully manage their liquidity.

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