Private credit is a powerful lever to generate prosperity during difficult economic times. It allows businesses to expand, hire more workers and invest in new technologies. It also enables householders to maintain their spending power and support local economies. As many investors move away from the risk and volatility of public markets, private credit is positioned as an increasingly important component of many investors’ portfolios. In fact, approximately US$1.4 trillion is expected to be raised by 2025. This article overviews the role that private credit has played in prior recessions and posits that it will have a meaningful and positive impact during the current economic malaise.
July 1st, 2022
The global financial crisis was a painful reminder of the vital role that private credit plays in powering economies. When Lehman Brothers collapsed, it sparked a chain reaction that quickly led to widespread panic and a dramatic contraction in lending by banks. This stopped the flow of money to businesses and households, causing them to cut back on their spending, exacerbating the downturn. Government stimulus programmes did help to some extent, but they were not enough to prevent a sharp rise in unemployment and a long period of economic stagnation.
The recovery only really began when private lenders started extending credit again, first cautiously and then with greater confidence. This highlights an important point: government intervention can provide short-term relief during periods of distress, but it is the private sector that ultimately drives growth and creates jobs. For this reason, policies that encourage private lending are essential for ensuring prosperous times ahead.
Low interest rates
Low interest rates are one way to achieve this goal – they make borrowing cheaper and so stimulate demand for loans. Another is by providing guarantees or other forms of support to reduce the riskiness of lending, which encourages banks and other lenders to increase their activity. Both these measures have been employed by governments around the world since the crisis hit, with varying degrees of success. In Europe, for example, low interest rates have helped spur a modest recovery but high levels of public debt mean that there is little scope for further stimulus without incurring unacceptable levels of inflationary pressure. In contrast, China has seen much stronger growth thanks largely to its aggressive use of state-backed loans to fund infrastructure investment. This has kept its economy humming along nicely despite headwinds from slowing global trade flows and weakening domestic consumption.
The 2008 financial crisis fueled an expansion and diversification of lending strategies. As market tribulations worsened, extensive regulatory changes were enacted which resulted in a reduction of lending from banks to small and mid-size companies. In response, private credit funds stepped in to provided loans that helped facilitate the growth and stability of many of these companies. Without private credit loans, this foundation of the U.S. economy would have struggled to find adequate financing to ensure their survival in both the short and long term.
Not widely known is the important role private credit played helping to mitigate the risks of bankruptcy for thousands of businesses during the Covid-19 pandemic. While the onset of the pandemic saw fear of a global loan default crisis, unprecedented liquidity from massive monetary and fiscal stimulus ensued. In addition to government stimulus programs, over US$100 billion in private credit was deployed in 2020 as a creative financing solution to help companies first survive and then grow. Unlike during the Global Financial Crisis where market dislocation existed for approximately 15 months, the pandemic produced a relatively short period of dislocation. Per the Proskauer Private Credit Default Index, US private loan default rates peaked at 8.1% in Q2’ 2020 before falling back to 1.04% in the fourth quarter of last year.
Private credit is poised to provide flexible funding solutions to companies impacted by current economic trends. Presently, the United States and other major economies face significant inflationary pressures on its economy relative to the implications of the Ukraine war, supply chain issues, increases in consumer demand, etc. With volatile public markets and interest rates increasing, fixed income investors may have difficulty earning a sufficient return on their long-term investments. Thus, such investors face both a rate and duration risk. Private credit tends to be structured as floating rate loans, implying that income can rise alongside interest rate increases which can mitigate both the rate and duration risk. In times of economic instability, private credit has been known to thrive. Bill Sacher of Adams Street indicated that as of September 2021, there remained over a 9:1 ratio of demand versus supply for credit with over $1 trillion in debt financing demand in the coming years.
While U.S. banks are facing increased regulation, private lenders have fewer regulatory constraints. As many banks operate more and more conservatively, private lenders can fill the resultant void with nimble financing solutions. As banks limit their risk by shedding non-performing credits at a discount, secondary market opportunities will likely increase for private credit managers. Seasoned private credit managers will be able to step in where banks might be reluctant to provide rescue capital and become debtors-in-possession. Experienced private credit managers can structure creative and relation-based financing solutions that banks may not be able to provide.
Last year $191.2 billion was allocated to private credit, the highest annual amount since 2017. Blackstone raised $32.6 billion for its private credit fund while Ares Management raised $8 billion for its direct lending fund. Calpers, the $482 billion U.S. pension fund, and California State Teachers’ Retirement System, the $320 billion pension fund, both increased their private credit allocations last year. Each pension fund is now constructed with a 5% private debt allocation target.
As U.S. companies face headwinds and banks retreat, private credit is contributing to a more vibrant financial system and will allow more companies to traverse the current economic environment. In spite of the many challenges, private credit can be a powerful tool for development in developing countries. When properly designed and implemented, private credit can help to finance investments in productive activities, support small businesses, and provide access to essential services. Private credit can also help to reduce poverty and inequality by providing opportunities for people with limited resources. While there are risks associated with private credit, these can be mitigated through careful regulation and supervision. With the right policies in place, private credit can play a key role in promoting economic growth and development in developing countries.
President, CEO and Co-Founder, 1K Africa
Co-Founder & Chairman, FLC Credit Partners & Family Legacy Capital
The opinions and views expressed herein are solely those of the author and do not necessarily represent the view(s) of any affiliated institution or organization including without limitation 1K Africa, Family Legacy Capital Credit Management, LLC, Family Legacy Capital Management, LLC, and any investment fund, entity or vehicle managed by or affiliated or associated with any of them.