Being an aspiring commercial lawyer often means being confronted by complex, often abstract, concepts leading to an often impenetrable wall of jargon for students and trainees. Next up in our Legal Lingo series, which we've introduced to help break down this jargon, is an explanation of what private credit is.
Private credit is currently a hot topic in leveraged finance. Private credit is a form of financing provided by entities which are not commercial banks. Historically, banks provided loans for the private equity backed acquisition of M&A targets and any associated post-closing working capital needs of the new portfolio company.
Private credit (which, broadly, takes the form of loans provided by non-banks) pitches itself to lenders as more flexible and faster than traditional banks as private credit deals can be executed offering bespoke financing terms, and often with more speed and certainty than with a large syndicate of lenders. The ability to provide more flexible terms comes from the fact that private credit lenders are not usually constrained by the risk tolerance policies and financial regulations that apply to commercial banks. Note however that it is unlikely that private credit lenders will be able to provide working capital facilities to portfolio companies.
There are various types of private credit, including, but not limited to, direct lending, distressed debt and special situations. The most common type is direct lending, which involves providing credit mostly to private, non-investment-grade companies. Sometimes, these companies may struggle accessing credit from banks and the public markets due to a heightened risk of payment default. Private credit investors with a greater risk tolerance may be desirable in such situations.
Private credit may also offer a financing solution to companies who are in earlier stages of their growth cycle. The greater risk to direct lenders stems from the illiquidity of private credit. Private credit instruments are typically not traded and the risk cannot be spread in the same way a syndicated loan would be. However, this also means direct lenders can often obtain better pricing (i.e., can charge more for the loan), such as a form of premium, in order to compensate for the greater financial risk.
In the face of heightened geopolitical uncertainty with the war in Ukraine, increasing inflationary pressures and coordinated interest rate hikes by central banks globally, private credit has demonstrated extraordinary resilience as compared to other asset classes, including traditional bank loans. Private credit loans afford greater structural protections than bonds and syndicated loans. Their floating rate nature effectively hedges against interest rate risk and investors have many more opportunities to intervene at an early stage as loans are closely held by a small group of lenders.
Private equity firms are increasingly turning to private credit to finance their portfolio companies owing to the flexibility, speed of execution and confidentiality such loans offer. Private credit markets are expected to experience further growth as private credit solidifies itself as one of the preferred methods of finance for private equity houses.
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