This post was authored by T-REX CEO and founder Benjamin Cohen.
Since the Global Financial Crisis of 2007-2008, the private credit market has seen exponential growth, expanding more than six-fold. Today, the private credit market stands at an impressive $1.5 trillion and is projected to continue expanding, reaching up to $1.8 trillion by 2025, offering vital support to borrowers during times of economic uncertainty.
The market has already drawn a wide range of new borrowers and investors including asset managers, pension funds, and others seeking higher returns. Lenders have played a pivotal role in supporting these borrowers, who struggle to obtain financing from traditional banks. Not only are private firms willing to take on more risk than banks, but they also offer flexibility in tailoring credit solutions to the specific needs of borrowers. Private credit funds can structure deals more creatively, accommodating unique circumstances and underwriting customized financing arrangements.
While the rapid growth of the private credit market presents opportunities, it also poses significant challenges. As the market matures, there is an expectation amongst investors that there will be similar refinement in the level of service offered. Unfortunately, the sheer volume of demand is putting immense pressure on the industry’s operational infrastructure, and cracks in the underlying technological infrastructure are beginning to appear.
Lessons To Be Learned From Structured Credit
When it comes to investor appeal and expectations, private credit still has much to learn from the more established markets of broadly syndicated lending and structured credit. These types of deals offer transparency, liquidity, risk distribution, diversification, and a sophisticated ecosystem of product evaluation; both through regulators such as the SEC and rating agencies. By contrast, private credit lending is perceived as an “opaque” market, characterized by significantly less certainty and liquidity than other markets.
Private credit lacks a mature secondary market and the underlying assets are largely illiquid. Structured credit, on the other hand, leverages the process of securitization to convert illiquid assets, such as loans and mortgages, into tradable asset-backed securities. The enhanced liquidity allows investors in structured credit to buy and sell their positions more easily, providing greater flexibility and diversification.
Securitization also allows structured credit to cater to varying appetites of risk exposure by creating multiple bond classes or tranches. Unlike the more direct exposure of private credit, securitization is designed to redistribute prepayment and credit risk among different bond classes, providing further transparency to rating agencies and other stakeholders.
By allocating credit and prepayment risk to different tranches, investors can choose the level of risk exposure that is best aligned with their institutional risk appetite, mandated or not. Though credit quality can be weaker in certain private credit investments, the flexible design of the structures and diversified strategies can account for risk-adjusted returns.
Private Credit Deals Bypass the Conventional Guardrails of the Ecosystem
As private credit continues its exponential growth, global regulators have started to take notice. There are growing concerns that the rapid growth of private credit and the lack of a secondary market may lead to a concentration of assets among a small number of market participants, potentially posing systemic risks to the broader economy.
The private credit market is largely free of regulation and highly leveraged. Unlike syndicated debt, private credit lending is not subject to Leveraged Lending Guidelines. Additionally, most private credit deals are not rated or subjected to significant disclosure requirements, making it challenging for investors to assess the true risk and credit quality of these investments.
While leverage can amplify returns during favorable economic conditions, it also increases the vulnerability of borrowers during economic downturns or times of financial stress. As the private credit market grows and borrowers accumulate more debt, concerns arise about the potential risks that could be triggered by economic shocks. If there is a broad deterioration in credit quality within the private credit sector, it has the potential to cause cascading disruptions across the capital markets and the broader economy. Because of this, the market must grapple with the question:
As the market continues to grow, private credit funds will continue to face heightened regulatory scrutiny, leading to the need for greater transparency and risk management. This regulatory attention will likely prompt private credit investors to adopt technology solutions that can help them keep up with a dynamic regulatory landscape and enhance transparency in deal evaluation and monitoring. Ultimately though, it is incumbent on leading private credit investors to proactively facilitate greater transparency and accountability to reduce the urgency of onerous regulation.
Private Credit Success Undermined by Lack of Tech Infrastructure
Companies like Blackstone and KKR have achieved tremendous success in the structured private credit market by strategically recruiting professionals from the asset-backed securities (ABS) industry. These teams have the background and experience to originate attractive opportunities and conduct thorough due diligence on potential investments. Additionally, the organizations backing these teams have had the ingenuity to proactively source capital from new pools of funding, expanding their reach to insurance companies and even regional banks. By combining talented teams and diversified funding sources, these firms have solidified their position in the private credit market and are able to quickly act on the most attractive opportunities.
Administrative Burden
Unfortunately for these highly capable front office teams, they’re ill-equipped to cope with the administrative burden of this growing market. These funds are the victims of their own success and their systems simply cannot support the volume or sophistication of transactions they are onboarding, funding, and monitoring.
Cash Drag
In addition, lenders are becoming increasingly aware of the cash drag that arises due to inefficiencies in data reconciliation and processing. When capital is needed for a deal, the delay caused by the lack of a streamlined data management system can result in cash sitting idle for weeks, leading to delayed funding and returns, and even missed opportunities. This cash drag effect becomes even more detrimental during rising markets, as cash tends to underperform, negatively impacting overall portfolio returns.
Complex Deal Terms
Another challenge emerges from the flexibility of private credit underwriting. While the front office benefits from being able to originate and underwrite highly customized transactions, the supporting infrastructure often struggles to keep up. It is impossible to avoid highly fragmented and disparate data; funds have to cope with multiple sources of deal data, each source using multiple formats, and due to the bespoke underwriting, each individual loan structure is also unique. This data fragmentation hampers an organization’s ability to deploy capital efficiently, provide transparency into portfolio performance, and issue accurate and timely reporting on loans.
Lack of Data Integrity
In traditional systems, trustees play a significant role in ensuring data integrity for the deals they monitor. However, this approach breaks down in the private credit market, where data comes from a more fragmented set of sources, involving thousands of servicers, trustees, and agents. Unlike public deals, data with common standards is not transparently available in private credit, and there isn’t an industry-standard tech stack. To date, the private markets have used mostly manual efforts for data management and analytics. At lower volumes, this could suffice, but with the current boom in private credit, this is no longer sufficient to cope with the scale of transactions conducted by successful private credit firms. Ingesting data, performing quality control, and making the data usable requires specialized software that can handle the intricacies and breadth of private credit data.
How To Build Data Infrastructure To Match
It is essential to build a robust middle and back office infrastructure to support the success of dedicated private credit teams and facilities. Institutions need sophisticated systems that can efficiently manage and support the volume and complexity of their transactions.
As an example, insurance companies invested in direct lending deals require transparency to continually stress test portfolios to meet their regulatory reporting requirements. At present, private credit deal reporting is often provided to insurance companies or pension funds a quarter late and lacks much of the detailed data required. This limits their ability to deploy additional capital into future investments and increases their risk and compliance burden.
An enhanced technological infrastructure with access to accurate and timely data will enable holistic risk analysis, faster scenario modeling, real-time covenant and performance monitoring, and deeper analysis for all aspects of these investments. Furthermore, it allows for a single source of truth, improving the accuracy and reliability of their data. Taken together, this allows firms to achieve better data integrity, streamline decision-making, ensure faster capital deployment, and provide seamless reporting to all stakeholders.
In a unit economic analysis, the proper technology infrastructure had incredible results. Some funds were able to increase their margin by over 3% thanks to improved risk management, data quality, and cash drag. When considering the billions going into private credit investments, these numbers signify meaningful increases in returns.
Beyond the cost impact, improved data integrity gives firms two key capabilities. First, it allows for the ability to benchmark against similar deals and conduct trend analysis, enabling market participants to identify emerging opportunities and make more informed investment decisions. Second, and perhaps most significantly, it enables faster capital deployment, addressing the cash drag that currently hampers the market. This enhanced efficiency and transparency will benefit not only investors but also borrowers, who will be able to access funding more readily and on better terms.
The Future of Private Credit
Despite some roadblocks, the potential for the private credit market is still tremendous and there are several critical areas in which it might expand.
A Secondary Market
Potential areas for growth within the market, such as establishing a secondary market, is garnering a mixed reception. A secondary market might help lenders to better manage their portfolio mix and free up capital for new deals, but there is concern that over time it would negate the yield premium private credit currently commands, as borrowers will no longer be able to rely on the benefits of an established relationship with their lenders. Instead, these transactions will behave much the way they do in a public setting with larger banking institutions.
Private Credit Funds Break into Asset-based Lending
The private credit market is currently experiencing unprecedented growth, backed by substantial market players with a long-term vision.
In an environment where over half of the debt in the U.S. is outside of the banking system, direct lending, a core subset of private credit, has refocused its efforts on winning more of the asset-based lending (ABL) market, as companies that are “asset rich” search for more liquidity. It’s no wonder that Blackstone President Jon Gray stated earlier this year that we are experiencing “a golden moment for private credit.”
Embedding ESG Covenants Into Deals
Because private credit regulation is still developing, there’s also the opportunity to incorporate ESG considerations into deal frameworks from the start and build out reporting requirements to incorporate them. By building ESG reporting into deals from the beginning, private credit funds are able to use their agility and evolving infrastructure to avoid the challenges faced by established industries like public ABS, ensuring long-term sustainability and a competitive edge.
To reach its full potential and have an enduring meaningful impact on a global scale for investors and borrowers alike, a significant development in the private credit market’s infrastructure is necessary. This marks a turning point for the nascent private credit technology, which must evolve for the asset class to achieve investability en masse while still mitigating emerging risks.
Unlike certain transient trends of the past, such as SPACs in 2021, the private credit market’s growth is being driven by the participation of highly sophisticated investors who are leading the charge to build sustainable and scalable infrastructure that can deliver long-term viability for large-scale investment. While this transformation won’t occur overnight, the current momentum indicates that the private credit market is on the path toward greater maturity and influence in the global investment landscape.