Private credit: a new asset class is born but how will it grow?
The breakout is complete. Private credit is no longer the side-show. It has become a key allocation option for the global savings system.
Since the financial crisis, a trillion dollars has been invested in private credit funds of many shapes and sizes. At SuperReturn International this year, David Rubenstein, Co-Founder and Co-Executive Chairman of The Carlyle Group, predicted that private credit will go on to outsize private equity itself. Nothing is certain of course, except death and taxes, but the logic and the momentum are there for this market.
So, now that we have a functioning asset class, how will it evolve and grow from here? Now that we are independent of the banks, can we learn from other sectors, even Silicon Valley, to ensure healthy growth for all concerned?
The 1.0 to 4.0 private credit sequence
One framework in which to see the future is in the classic 1.0 to 4.0 sequence.
The current market is private credit 1.0. Funds are raised from institutions and between 10 and 50 loans are made by each fund to companies to assist their owners or their new buyers with financing. An annual management fee is charged by the fund manager. A performance fee is also paid if the fund beats certain targets. Over 300 such managers exist according to industry data gatherers. The cumulative amount of capital committed to these managers since 2010 is over $800bn. Many are well-placed to operate through cycles, as long as they keep powder dry or raise more capital. They have accumulated industry expertise and contacts. In a crunch, their patient capital may well be important for mid-market firms trying to ride out storms.
Private credit 2.0 – the use of technology by lending platforms to process large numbers of borrowers and of machine-learning to improve underwriting – also already exists in a big way. In a private credit 3.0 world distributed ledger technology (DLT), as pioneered by the blockchain, could start to remove much of the need for third party evaluation. It could bring more certainty and efficiency to risk management, to KYC and to workout. Ultimately, credit markets in a private credit 4.0 world could deploy DLT and smart contracting to automate most of the actions required in the effective provision and management of corporate credit.
The rise of direct lending 2.0
The fastest-growing segment of private credit is now being brought by tech and data powered lending platforms – “direct lending 2.0”. Over 250,000 SMEs have borrowed more than $27bn from marketplace lending platforms, not including China. These groups have evolved from their P2P roots and business models are being re-examined, which is healthy. Several, such as Auxmoney, Funding Circle and Lending Club are now large originators and servicers of hundreds of thousands of SME and consumer credits direct for pension funds and insurance companies. Just one UK-based platform originating loans of around 100,000 pounds per clip made more loans of that size to UK companies than the entire UK banking system managed in Q4.
As much as 90% of SME platform lender recoveries have come from guarantees.
As well as passing through comparable yields to the 1.0 funds, platform lenders are so far also showing solid default and recovery. In the SME segment, personal guarantees of company directors matter at this loan size. This aligns business owners with lenders in a way that private equity lending does not. As much as 90% of SME platform lender recoveries have come from guarantees. This may change in a deep recession, but the platforms have generally been able to show investors credible forward analysis and underwriting plans for a turn in the economy.
Showing the ‘virtuous circle’
So often at this stage in a cycle, when the demand for investments matches the supply, people start to stretch the core principles of credit. Is the origination technology being deployed by the direct lending platforms able to shift out the curve that sets volume against quality, without the problems of the past?
An effective framework with which to look at credit markets is either as “virtuous” circles or as “vicious” circles. In the virtuous circle, the most eligible borrowers come forward. Lenders then get clean, direct data about potential borrowers. They then build better models. They can ensure pricing is appropriate. Their investments perform. More capital is attracted. More borrowers can be reached and more data is accessed. Around it goes and everybody is happy.
But in the pre-2008 vicious circle, as more capital was committed pressure was increased to lend. Underwriting processes deteriorated. Chains of intermediaries introduced the borrowers. Data was often poor, sometimes fraudulent. Modelling worsened. Pricing was either wrong or unattractive but was obscured by complex structuring to keep the capital coming. Ultimately the buyers, smelling a rat, went on strike. Investors redeemed. Depositors ran and the banking system failed, taking insurance down with it.
Fundamentally, platform lenders like Lending Club and Funding Circle live by the virtuous circle. Lending to hundreds of thousands of small firms and consumers, they constantly add richness to their modelling. The transparency and the short chain between the borrower and the institutional lender does not seem to allow for the originate-to-distribute transaction culture which dominated the market pre-2008. Funding Circle now has over 800 people worldwide, a quarter of whom are in risk or underwriting.
Discipline secures the future
The mantra among investors which has proved important in the past is ‘alignment of interest’. It is here that some investors still have concerns about the 2.0 lending platforms. Much of this concern stems from unfamiliarity. Again, the virtuous circle is a useful way to look at the alignment.
Platforms need to be obsessive about their transparency. Black boxes won’t raise capital and keep the circle going.
Platforms in many cases are not charging the usual annual management and performance fees in the private equity/private debt fund model investors are used to. So what incentive does the platform actually have to make sure that the loans they make perform well and are managed intensively during their term?
The answer is that to keep the virtuous circle going the lending platforms, like banks, above all need to be disciplined. The machines need to source and crunch all the right data. The humans need to act on the data they see. Finding ‘alpha’ and outperforming benchmarks is not the name of the game. For this reason, the alignment of interest for investors is in the platforms needing to run the most disciplined operations in the market with the lowest default rates for a given return level, to be able to attract the most investors - in the virtuous circle.
To do this, the platforms need to be obsessive about their transparency. Black boxes won’t raise capital and keep the circle going. Platforms employees need to be paid on performance metrics and are most often stock holders. This way the suffer for downside and enjoy the upside of their company’s growth. Discipline will come through the right staff incentives, strategic foresight, world class risk management and a culture of ethics. Whatever the technological developments in the credit market, these are the requirements of all participants, whether it is the humans or the programmes of the machines.