We are delighted to introduce this year’s edition of Financing the Economy, the latest study of the private credit industry by the Alternative Credit Council (ACC), the private credit affiliate of the Alternative Investment Management Association (AIMA). This year’s research, produced in collaboration with Dechert LLP, comes as the private credit industry reaches an important inflection point. Whilst previous editions of Financing the Economy focused on how the industry, already prominent in the US, established itself around the world as a credible alternative to traditional sources of finance, the past 12 months have seen it cement its place in the lending landscape globally.
Our research indicates that the private credit industry could pass the symbolic $1 trillion milestone by 2020. The industry’s growth underscores the increasing influence private credit is having on financing the economy at large. Having gained momentum from the 2007-8 financial crisis, the private credit industry is now lending to businesses at record levels, creating jobs and supporting economic growth around the world. Throughout this report, there are numerous examples which illustrate how private credit is contributing to financing the real economy.
This growth has fuelled further interest in private credit, and attracted new players with innovative strategies. That, in turn, has led to an expansion in the reach of the industry, and has allowed more borrowers than ever to finance their businesses using private credit. However, our research shows that increased market competitiveness has not compromised those key aspects of private credit that are most valued by borrowers. The industry still rapidly delivers flexible and attractive finance to businesses.
The flexibility shown by many private credit managers with respect to loan covenants is matched by their focus on lending standards and commitment to robust risk analysis. Concurrently, the preference of private credit managers for senior secured positions within the capital structure means that they are well placed to protect the interests of their investors. Participants in our research also affirmed their commitment to identifying and working with creditworthy borrowers, even if those borrowers have greater bargaining power than in previous years.
From an investor perspective, performance across the private credit sector continues to show strong yield relative to many other asset classes. Specifically, the potential returns of direct lending funds (reporting in a range of 10%-15% IRR returns on average1), which generally maintain a position higher in the capital structure than mezzanine and distressed debt providers, remains an attractive prospect in alternative investing as we move into the end of 2017. This has helped fuel the fundraising uptick in the strategy, as investors hope to capture continued outperformance in the future.
Heading into 2018, the momentum in the development of the private credit industry shows no sign of slowing. As the value of this form of funding becomes better understood by policymakers, we are seeing the introduction of supportive legal and regulatory reforms. With private credit offerings emerging in new regions, the industry is now truly global.
Chief Executive Officer, AIMA
Chairman Alternative Credit Council and President Cheyne Capital
Partner, Financial Services, Dechert LLP
Industry growth: The private credit industry is on track to reach around $1 trillion in assets under management (AUM) by 2020, according to ACC and Preqin data. The historic compound annual growth rate of 20% of the industry has seen the sector increase in size 14-fold since 2000, reaching over $600 billion by the end of 2016.
Global market: Private credit activity in the US remains strong. The popularity of the US market is also helping to fuel interest in the European and Asia Pacific markets, as managers look for new growth opportunities. Our survey identifies Germany, the UK, the US, France and Canada as the five countries that will offer the biggest opportunities over the next three years to 2020. Meanwhile, regulatory reforms in Europe and Asia Pacific are supporting the sector as it expands into new markets.
Lending to companies of all sizes: Smaller businesses are now the largest category of borrower, receiving over 40% of all lending by private credit firms. Almost a fifth (18.4%) of lending now goes to large corporates. Private credit managers are increasingly lending to infrastructure and real estate based operations via a host of arrangements supported by other private credit market participants or in collaboration with banks. While over 40% of managers target loan sizes between $25-100m, around 20% of managers are targeting loan sizes in excess of $100m.
Borrower satisfaction: Flexibility of terms, speed of decision making by fund managers and an ability to finance complex deals are regarded as the key attractions of private credit for borrowers. Borrower attitudes towards private credit financing as an alternative to equity financing are also becoming more favourable. Many borrowers, especially among SMEs, are wary of diluting their equity stake in their businesses and find the flexible approach of private credit more attractive.
Evolving borrower-manager relationship: Private credit managers are having to demonstrate more flexibility as both covenant and coupon terms have shifted more favourably towards the borrower. Nearly half of private credit managers stated that covenants had become less demanding over the past three years with only 14.3% of firms said loan terms had become more demanding. Private credit managers are also responding to borrower preferences for covenant-lite structures (historically more common across larger syndicated loan transactions with institutional investors) to be included in private credit transactions.
Expansion of deal origination networks: Managers are diversifying the ways they source potential credit opportunities. Nearly one third say their primary avenue to source potential opportunities is through the relationships and networks they have established within their given industry. Managers are also continuing to look to banks, private equity managers and other industry advisors to help them source new financing opportunities.
Long-term investment: Nearly two-thirds of managers say their preferred target term for investments is now between two and six years, while almost a quarter have a target term of six years or greater (up from only 8% in 2015).
Fund manager discipline: Creditworthiness and sourcing viable opportunities remain the most resource intensive activity for 85% of private credit managers. Levels of leverage remain low across the sector where nearly half (44%) of all managers use no leverage at all.
Fund structures to support lending activity: Almost 70% of all participants have closed-end funds, with 52% being closed-end with fixed maturities. For the roughly 30% of managers with open-ended funds, lock-ups or other liquidity management tools restrict or prohibit fund withdrawals under certain circumstances.
Fund domiciles: The most common domiciles for private credit funds are Luxembourg, the Cayman Islands and the US. Other popular domiciles include Ireland, Jersey, and the UK.
Demographics of survey participants and methodology
The findings contributing to this year’s Financing the Economy paper come from three distinct sources. First, the Alternative Credit Council (ACC) encouraged its members to participate in an online quantitative survey – the results from which form the basis of this paper. Second, the ACC and Dechert engaged in a series of structured interviews with a variety of private credit managers from the US, the UK, Europe and Asia Pacific to explore the strategies that they deploy in their private credit investments and supporting operations. Finally, participants were invited to contribute a case study to the paper in order to give practical examples of how they are providing finance and support to the real economy. Evidence taken from these case studies can be found throughout this paper. All case studies, including those within the body of this paper, can be found in Appendix 1.
Much of the overarching terminology used to describe the non-bank lending industry is applied interchangeably and regular participants will be familiar with phrases such as ‘direct lending’, ‘alternative lending’, ’non-bank lending’, ‘private credit’ and ‘private debt’. For the purposes of this paper, we use the term private credit as the umbrella term to describe all forms of debt finance provided by non-bank lenders. A glossary is also included at the end of this paper in Appendix 2, which identifies some of the other terminology used both within this paper and in the private credit industry more generally.
Private credit is now a globally established source of mainstream finance
A) Continued growth in private credit: In earlier editions of Financing the Economy, we highlighted the increasing influence of private credit within mainstream finance and its role supporting the real economy. While this trend (in certain jurisdictions) is still in its early stages, this year’s analysis supports the view that the shift taking place from traditional bank lending towards private credit is a permanent one. Evidence of the continued development of the private credit market is provided by the 60 participants who contributed to this paper. As a measure of their influence, they collectively represent approximately $500 billion in assets under management (AUM) , with more than $350bn of that figure being allocated to committed capital and a further $150bn (or approximately 30% of total capital) representing dry powder.
B) Expanding into new markets: Evidence of private credit’s increasing influence can be seen through its broader take-up across countries in Europe and Asia Pacific, as well as in the industry’s cornerstone US market. The continued strength of the US market is demonstrated by the finding that nearly half of all participants in this paper name the US market as being the market in which they are most active. The US, UK and France make up the top three largest private credit markets in which this paper’s participants are most active. These three countries account for over 80% of the total size of the market in which participants in this paper invest.
A) Private credit is as attractive to borrowers as ever: The capability to provide tailored solutions to a borrower’s financing requirements has featured strongly in previous editions of Financing the Economy. Specifically, the top three factors that borrowers value most about private credit, as demonstrated by 85% of participants, include the ability to carry out complex structures, flexibility of terms, and speed of decision making (Figure 9). These findings support the view held by private credit lenders that borrowers typically consider non-price related factors to be particularly important when evaluating their financing options.
B) Focus on the lending process: Private credit managers consider their expertise in credit risk analysis and due diligence on potential borrowers as a key competitive advantage over other types of lenders. In recent years, the private credit industry has built up a great deal of expertise in this area, allowing private credit managers to move away from the more standardised approach typically employed by traditional lenders.
C) Borrowers are in a strong position: Covenants provide security for both lenders and borrowers against the other party in the loan agreement acting in a way that is detrimental to their interests. Similarly, the price and structure of the loan coupon (i.e. pricing) aligns payments to suit either the lender or the borrower’s requirements. Changes in loan covenants and coupons can thus be a useful indicator of the relative balance of power between lenders and borrowers in the credit markets.
D) Expansion of deal origination networks: With the continued growth of the industry, private credit managers are diversifying the ways in which they source potential investment opportunities. As shown in Figure 19, nearly one third of all participants state that their primary avenue to source potential opportunities is through the relationships and networks they have established within a given industry. Instead, more managers are looking to banks, private equity managers and other industry advisors to help them source new financing opportunities. This shift suggests that private credit managers are adopting a pragmatic approach towards deal flow in the face of an increasingly competitive market.
E) Collaboration between private credit managers and banks remains as strong as ever: Collaboration between private credit managers and banks or credit institutions in producing new lending solutions or sourcing new credit opportunities remains a prominent feature of the private credit market, as shown by Figure 21. From a bank’s perspective, collaboration with private credit managers helps them deal with a number of familiar scenarios. These may include instances where a bank:
- Prefers to syndicate the loan;
- Is unable to provide both the working capital facility and loan simultaneously; or
- Where the loan is too small to sit on its balance sheet.
In all these instances, collaboration with a private credit manager enables the bank to retain its relationship with the borrower despite not being able to service the entirety of that borrower’s financing requirements. These arrangements continue to benefit borrowers across the industry as the combined strengths of banks and private credit providers working together make it more likely that they will receive the finance they need to invest in their business, support jobs and boost economic growth.
F) Sponsor influence remains strong but sponsorless deals continue to grow in popularity: Sponsored lending describes loans to borrowers where a private equity sponsor owns equity in the borrower. In these transactions, the private equity sponsor's expertise and relationship with both the borrower and private credit manager often helps facilitate the loan. Borrowers backed by private equity sponsors represent only a small percentage of all businesses, yet the majority of finance provided by private credit managers typically involves sponsored lending.
G) Managers are moving beyond the mid-market
A) Capital structures used by private credit managers: Private credit managers are able to offer various types of funding structures to borrowers8. This is attractive for the borrower as it provides them with more options to suit their financing needs.
B) Common coupon structures used in lending: Across the various capital structures that were researched for this paper, the most popular pricing structure is the floating coupon. Notably, over 60% of all senior secured structures and over 70% of all unitranche structures are priced using floating rate coupons. These findings are arguably the broadest indication that borrowers of private credit finance are neither unduly concerned about interest rates being raised over the short term, nor about how any impact this would have on their ability to make payments on the financing being provided.
C) Fund structures: Fund tenors, deal terms and structures across the participants in this paper’s research share some similarity to private equity funds. Typically the majority of private credit managers prefer a short-term investment period (two to four years), although longer maturities (six years or greater) are becoming more common mirroring the longer loan terms on offer to some borrowers.
I. Fund liquidity
II. Use of fund leverage
III. Fund vehicles
Financing the Economy 2017
The role of private credit managers in supporting economic growth
Download the full report here