Accelerate Liquid Private Credit Monitor – Q4 2024

December 14, 2024 – The exact definition of private credit has been quite nebulous. Most often, the term private credit refers to senior-secured, floating-rate loans provided by an investment fund to a sponsor-backed (private equity-owned) private company. However, it can also refer to non-sponsor backed lending, real estate lending, equipment finance, collateralized loan obligations, and more. Even peer-to-peer lending can qualify as private credit. Lending $5,000 to your nephew so his rock band can go on tour? Yep, that can be private credit too.

But mostly, private credit refers to the debt financing of leveraged buyouts in the United States.

Unlike traditional loans from banks or the broadly syndicated loan market, private credit typically involves bespoke, negotiated terms and is often provided to companies that do not have access to public capital markets. Private credit loans are mainly used to finance the private equity industry, specifically, the debt financing of LBOs. These direct loans may have one, or multiple, lenders. Since the private credit industry is largely focused on lending to lower-to-middle market private companies with higher than average leverage levels, it is considered sub-investment grade credit.

From humble beginnings a couple of decades ago, private credit has proliferated over the past several years, recently surpassing $1.5 trillion. It is one of the fastest growing asset classes and is expected to double to more than $3 trillion by the end of the decade.

Given that private credit is relatively new, with its origins stemming from the strict banking regulations that came into effect after the Great Financial Crisis of 2008-2009, many allocators have questions regarding the asset class, including why it is so popular, if it is a bubble, and how to best access it.

1. Why is Private Credit So Popular?

The story behind private credit’s new found popularity is relatively simple. The main reason that the asset class is so popular is because it offers the highest yield compared to other investable asset classes. Private credit is one of the remaining investments that provides the prospect of double-digit yields for investors, far exceeding traditional high-yielding alternatives such as junk bonds and preferred shares.

Source: JPMorgan Guide to Alternatives, Accelerate

The notion of a double-digit yield, which represents an equity-like return, through contractually obligated secured loans resonates with investors. And with historical default rates in the low-to-mid single digits, combined with yields that are more than 5% above the risk-free rate, private credit has historically outperformed stocks for the current generation of investors. Equity-like returns with credit risk hold appeal for allocators.

The second reason investors are drawn to private credit is its floating interest rates, which have been particularly friendly to investors lately.

Conversely, it has been a challenging environment for fixed income investors over the past several years. The great bond bull market of 1980 to 2020, in which the U.S. 10-year bond yield steadily fell from more than 15.0% to a low of 0.5%, lulled investors into thinking that bonds could generate low-risk, consistent income without significant drawdowns. However, all that changed as yields started to rise, increasing from their 2020 low below 1.0% to nearly 5.0% by 2023. It turned out that investing in bonds was a big bet on duration, which left income investors nursing large losses when it went the wrong way. Given the fixed coupons associated with bonds, the perceived low-risk nature of the asset class turned high-risk, blowing a hole in investor portfolios as yields rose and bond values fell precipitously.

Private credit has far outperformed bonds over the past several years, not only because it offered higher yields, but more importantly, private credit offers floating rate yields. These variable rate coupons allowed investors to sidestep the losses associated with income investments as yields rose because the floating rates offered by private credit increased in lock-step with short-term interest rates.

The high-yielding floating rate loans symbolizing private credit helped diversify income investors’ portfolios by reducing the reliance on duration and the direction of volatile long-term interest rates.

2. Is Private Credit a Bubble?

Private credit has dominated the investment lexicon over the past couple of years. It is the topic du-jour of capital allocators, given the reasons discussed above. When an asset class exhibits significant growth in both size and profile in a short period, investors cannot help but ask whether said growing asset class is a bubble.

Twenty years ago, the buyout industry had less than $1 trillion of assets under management, matching that of the sub investment credit market (which consists of high-yield bonds, leveraged loans, and private credit). Note that LBOs utilize a significant amount of leverage (it is in the name), and are therefore heavily reliant on the sub-investment grade credit market to function. Historically, the loan-to-value of private equity buyouts has been around 50%, meaning that for each dollar in private equity, there should be a corresponding dollar in sub-investment grade credit.

Two decades later, the sub-investment grade credit market has grown to nearly $4 trillion, while the private equity industry ballooned to more than $5 trillion. Thus, the sub-investment grade credit market, including private credit, has grown roughly in line with the private equity industry that it supports.

Also, within the sub-investment grade credit market, private credit has taken significant market share from the junk bond market. Notably, private credit has increasingly taken market share from the junk bond market in funding leveraged buyouts due to several factors, including flexibility, speed, and tailored solutions offered by private credit providers compared to the more rigid and public nature of the high-yield market.

Source: Blackstone

In 2005, private credit accounted for just 8% of the sub-investment grade credit market. By 2023, its market share surged to 28%, at the expense of junk bonds. As the private credit industry has exploded in size, the junk bond market has stagnated.

Last quarter, it is estimated that private credit funded one-half of the leveraged buyouts.

Thus, the growth of private credit is rational and arguably not a bubble. It can be explained by two factors:

1. The growth of the private equity industry led to greater market demand for sub-investment grade credit.
2. The increase in private credit’s market share within sub-investment grade credit, as sponsors increasingly turned to private credit funds to finance their LBOs.

3. How to Access Private Credit?

There are a myriad of investment structures to access private credit, each with unique characteristics tailored to different investor needs and preferences:

a) Listed Business Development Companies (BDCs) – Publicly traded BDCs are regulated entities that provide loans and credit solutions to small- and medium-sized businesses. They can be easily purchased through brokerage accounts, similar to stocks as they trade in the secondary market on major exchanges (e.g., NYSE or NASDAQ). Examples include Blackstone Secured Lending (NYSE: BXSL) and Oaktree Specialty Lending (NASDAQ: OCSL). The SEC requires listed BDCs to file financial statements with highly detailed loan portfolio disclosure each quarter, readily facilitating in-depth due diligence and analysis of credit portfolios by allocators.

b) Unlisted Business Development Companies (BDCs) – These are private BDCs not traded on public exchanges, often structured to provide periodic liquidity through share repurchase programs. They are available through financial advisors, typically with higher minimum investments, and may include commissions. Liquidity is limited, with periodic liquidity events, such as quarterly redemptions through tender offers. Examples include Blackstone Private Credit Fund and Oaktree Strategic Credit Fund. Like their listed BDC brethren, unlisted BDCs are required by the SEC to file quarterly financial statements, which provide a line-by-line disclosure of their loan portfolios.

c) Direct Lending Limited Partnerships – Managed by private asset managers, these funds pool capital to provide loans directly to companies and are offered to accredited investors or institutions, often through private placements. Nearly all Canadian private credit funds utilize the limited partnership structure, and are not required to provide any disclosure or transparency to investors regarding their loan portfolios, making due diligence difficult. For Canadian allocators specifically, limited partnerships have fallen out of favour, replaced by higher quality, more diversified and transparent U.S. BDCs.

d) Interval Funds – These hybrid funds offer exposure to private credit while providing periodic liquidity for investors. They are available to retail investors through financial advisors or brokerages and trade similar to mutual funds. Examples include Cliffwater Corporate Lending Fund (CCLFX) and CION Ares Diversified Credit Fund (CADIX).

e) Private Credit ETFs – These ETFs provide exposure to private credit, often investing in loans, securitized assets, funds, or other private credit instruments. They trade on public markets, and are accessible to all investors. Private credit ETFs are liquid, as ETFs are traded like stocks. Examples include VanEck BDC Income ETF (NYSEARCA: BIZD) and Accelerate Diversified Credit Income Fund (TSX:INCM, INCM.U).

f) Managed Accounts – Customized accounts managed by private credit firms tailored to institutional or high-net-worth investors that generally require significant capital commitments and are highly illiquid, often tied to fund terms.

g) Peer-to-Peer (P2P) Lending Platforms – Platforms that connect individual investors directly with borrowers. These are generally open to retail investors, often with lower minimums and moderate liquidity. Examples include Prosper and LendingClub.

h) Private Credit Syndications – Large institutional investors participate in syndicated loans led by private credit managers. These co-investments are limited to institutional investors like pension funds, insurance companies, or endowments, and represent long-term commitments.

i) Real Estate Credit Vehicles – Funds or REITs specializing in private real estate debt, such as mortgage loans, are available via the public or private markets. Examples include Blackstone Mortgage Trust (NYSE: BXMT) and Starwood Property Trust (NYSE: STWD).

One of the most common access points for investors to allocate to private credit is through BDCs, either listed or unlisted. A Business Development Company is a type of investment vehicle in the U.S. designed to provide capital to small and medium-sized businesses. Created under the Investment Company Act of 1940 and regulated by the SEC, BDCs were established by U.S. Congress in 1980 to promote investment in small and medium private companies that lack access to the public stock or bond markets. To avoid corporate-level taxation, a BDC must distribute at least 90% of its taxable income to shareholders as dividends, similar to REITs.

Many private credit funds are structured as BDCs, given the ease of access for investors and tax advantages. BDCs are subject to SEC oversight and must meet specific requirements, such as maintaining an asset coverage ratio for leverage and providing transparency to investors, including their financial statements and detailed loan portfolios (as disclosed in their quarterly form 10-Q and annual 10-K on the SEC’s EDGAR). Given the significant transparency and disclosure provided by BDCs, these vehicles offer substantial analytical dynamics for investors to monitor.

As the BDC market has grown and matured, it has undergone a transformation. While initially home to sketchy private equity-like vehicles, such as the one hedge fund manager David Einhorn wrote about in his 2008 book, Fooling Some of the People All of the Time: A Long Short Story, the BDC sector has professionalized and is now dominated by the large alternative investment platforms such as Blackstone, Ares, and Apollo. The BDC structure turned out to be a near perfect vehicle for private credit funds, and most private credit platforms offer both listed and unlisted BDCs for investors to access their investment strategies.

In 2011, the listed BDC market was a niche market segment of just $10 billion in market value. Since then, it has grown to $72.5 billion in market capitalization today. Since BDCs generally utilize approximately 1:1 leverage, the $72.5 billion market cap across 41 listed BDCs holds $144.6 billion of private credit loans.

There remains a substantial overlap between the listed and unlisted BDC market for private credit vehicles. In fact, nearly all leading private credit managers offer both an unlisted, and listed BDC, often run by the same investment teams and featuring overlapping loan portfolios.

Note the similarities between the unlisted BDC market (table on the left) and the listed BDC market (table on the right).

Source: Accelerate, Raymond James

Not only are there “sister funds” between the unlisted and listed BDC market, but funds move between the categories, often from unlisted to listed through IPOs and mergers. For example, the following unlisted BDCs have moved to the listed BDC market recently (or are in the process of doing so):

• Morgan Stanley took its unlisted BDC, Morgan Stanley Direct Lending Fund, public on the NYSE in January of this year.
• Kayne Anderson took its unlisted BDC public on the NYSE in May of this year.
• Golub Capital merged its unlisted BDC, Golub Capital BDC 3, into its listed private credit vehicle, Golub Capital BDC, in June of this year
• Oaktree merged its unlisted BDCs, Oaktree Strategic Income and Oaktree Strategic Income II, into their publicly-traded Oaktree Specialty Lending in 2021 and 2023, respectively.

• Unlisted BDCs generally restrict liquidity to quarterly redemptions (subject to gating), while listed BDCs offer intraday liquidity in the secondary market.
• Unlisted BDCs offer subscriptions and redemptions at their net asset value (NAV), while listed BDCs trade at market prices that can be at a premium or a discount to their NAV.
• Unlisted BDCs generally have lower management fees compared to their listed brethren, however, they often come with upfront selling commissions of 1.5%-3.5% and trailing distribution fees.
• Both structures are public filers, filing 10-Qs and 10-Ks on the SEC’s EDGAR database, offering full transparency into the funds’ loan portfolios.

Source: Accelerate, Bloomberg

In addition, it may be worthwhile for allocators to compare the trading dynamics of a private credit firm’s listed BDC to its unlisted BDC (which will offer subscription and redemption at NAV). For example, currently, an allocator can subscribe to Oaktree’s unlisted BDC, Oaktree Strategic Credit, at NAV for a yield of approximately 10%. Alternatively, an allocator could look to Oaktree’s listed vehicle, Oaktree Specialty Lending, which trades at an -11.3% discount to NAV in the secondary market with a yield of 13.7%.

Introducing the Liquid Private Credit Monitor

In order to track the daily, mark-to-market dynamics of the private credit asset class, we have created the Accelerate Liquid Private Credit Monitor for investors to reference. This monitor analyzes and tracks all relevant factors within the liquid private credit fund sector tracking listed BDCs, such as NAV discounts/premiums, yields, loan portfolio characteristics, and more. The Accelerate Liquid Private Credit Monitor below represents all publicly-traded business development companies in the U.S.

Q3 reporting season for the BDC market wrapped up last month. Credit quality remained solid in the quarter, with non-accruals (loans in which the borrower has stopped making interest payments) remaining constant at around 2.0% of portfolios on average.

Direct lenders noted that new investment activity remained robust and credit performance remained healthy. Positive credit conditions stand in contrast to the first half of the year, with some large private credit loans getting written down and restructured. Examples of deals gone bad earlier in 2024 include Pluralsight, which was a $3.5 billion Vista Equity buyout from 2021 in which several lenders took write-downs of around 50% as the company was restructured and ownership transferred to the lenders, and Thrasio, one of the largest Amazon aggregators, which caused pain in several private credit funds earlier this year when it emerged from bankruptcy. There were no major credit events within the liquid private credit universe in the third quarter.

The liquid private credit segment continues to evolve, with most BDCs gravitating toward first lien senior secured loans. Loan spreads continued to tighten, falling to 450-550 bps during the quarter, with many direct lenders expressing confidence that the highly competitive conditions have subsided and spreads have stabilized. In terms of market segments, spread tightening was more pronounced in the upper middle market, with the core and lower middle market segments still enjoying higher spreads of around 550 and above. In addition, some private credit firms noted that, looking forward, they expect that spreads may widen as base rates fall, which has happened in past cycles. Most new private credit loans were struck at an average loan-to-value of around 40% in the third quarter.

While payment-in-kind (PIK) interest income remains topical and a concern from some investors, PIK levels remained relatively stable at 6.9% of total investment income, on average. That said, some lenders noted that much of PIK interest is structured from the onset given it is a benefit for borrower flexibility, and therefore an elevated PIK level is not necessarily a signal of credit distress. Funds are increasingly including PIK provisions upon loan origination, particularly for recurring revenue loans for software companies that are still burning through cash to fuel growth. Currently, most PIK interest is associated with performing loans that were originated with a PIK feature.

Given that buyout activity is a main driver of demand for private credit, many lenders noted the muted M&A environment this year, given the harsh regulatory environment for mergers and acquisitions, while expressing optimism for a marked increase in buyout activity in 2025 due to the U.S. election result and its resulting expected economic growth and deregulation.

The vast majority of the liquid private credit market is focused on lending to sponsor-backed companies, because the velocity of capital and investment opportunity in the sponsor world is much higher than the non-sponsor world. Private equity sponsors deploy capital at a more predictable pace with larger pools of capital. Not to mention, sponsor-backed companies have a lower default rate historically compared to non-sponsor backed companies.

The forward interest rate curve moved up post-election, and the market is pricing in just three fed rate cuts through the end of 2025. The current probabilities of changes to the Fed rate, as implied by 30-Day Fed Funds futures prices, implies that base rates will be around 3.85% by the end of next year, equating to average private credit yields of nearly 9%, assuming spreads remain stable.

The yen carry trade unwind in August, along with its associated market volatility, caused liquid private credit vehicles to trade down NAV discounts to widen markedly, with the average BDC going from a slight NAV premium in June to a >6% discount in August. In the four months since the volatility spike, NAV discounts have recovered.

While capital within the liquid private credit / listed BDC market segment remained relatively constant, one dynamic to note is the significant amount of capital being raised in the private wealth channel through non-traded BDCs. This flood of capital commitments is creating significant pressure to deploy capital at unlisted BDCs. We have seen some unlisted BDCs deploying capital into the broadly syndicated loan market as a stop-gap to deal with the rapid influx of new investor capital. That said, it is generally the mandate of a private lender to generate returns above what one can receive in the public loan market, so we do not expect the strategy of allocating to the broadly syndicated loan market to continue, particularly because it does not seem fair for investors to pay a premium fee to a BDC when they are allocating to public loans that are available in lower cost structures.

As long as current inflows persist, we expect private credit loan spreads to remain competitive. That said, the strong U.S. economy has led to positive performance for sponsor-backed private companies in general. Positive investment performance combined with elevated base rates makes for an overall attractive, but balanced, private credit market for allocators.

Each individual merger is assigned a risk rating:

• AA – a merger arbitrage rated ‘AA’ has the highest rating assigned by AlphaRank. The merger has the highest probability of closing.
• A – a merger arbitrage rated ‘A’ differs from the highest-rated mergers only by a small degree. The merger has a very high probability of closing.
• BBB – a merger arbitrage rated ‘BBB’ is of investment grade and has a high probability of closing.
• BB – a merger arbitrage rated ‘BB’ is somewhat speculative in nature and has a greater than 90% probability of closing.
• B – a merger arbitrage rated ‘B’ is speculative in nature and has a greater than 85% probability of closing.
• CCC – a merger arbitrage rated ‘CCC’ is very speculative in nature. The merger is subject to certain conditions that may not be satisfied.
• NR – a merger-rated NR is trading either at a premium to the implied consideration or a discount to the unaffected price.

The AlphaRank merger analytics database is utilized in running the Accelerate Arbitrage Fund (TSX: ARB), which may have positions in some of the securities mentioned.