In January, Institutional Investor published an opinion piece by Dan Rasmussen and Greg Obenshein titled “High-Yield Was Oxycontin. Private Credit Is Fentanyl.” In response, Drew Maloney – President and CEO of the American Investment Council and a former senior official in the U.S. Department of the Treasury – wrote the below for Institutional Investor.
Recently, there has been more coverage from all perspectives about the private debt market and its role in today’s economy. The reality is that businesses of all sizes across America turn to the private debt market for critical capital for operations and expansion – without relinquishing ownership or control.
These loans are the main means of borrowing for the roughly 70 percent of businesses in the U.S. that lack access to the public debt market, a group that includes countless household names and just about every local business in the U.S. Despite the recent growth in private credit lending, those loans represent less than 5 percent of the total debt market, roughly equivalent to the market cap of Apple – a single company.
Because the private debt market is comprised of loans to businesses that cannot raise investment-grade debt, some have compared it unfavorably to the borrowing binge and flimsy financial tools that fueled the financial crisis.
Those comparisons are inaccurate and unfair.
Most businesses lack access to public equity or debt – and most businesses are not “investment grade” – including a number of household names, such as American Airlines, Avis Budget Group, and Wynn Resorts.
This is particularly true for the small- and medium-sized businesses that drive our economy. Many of these companies will secure a “leveraged loan,” which simply means a non-investment-grade loan, to meet their credit needs. Because banks are less engaged in corporate lending than they were before the financial crisis, other entities have increased their lending to provide this capital to fund operations, innovation and expansion. The private debt market has existed for years, but banks are no longer its dominant players.
Banks reduced their private lending in large measure because of rules established in the wake of the financial crisis that forced these institutions to reduce their overall loan exposure and limit their ability to engage in trading. Private credit funds and other non-banks have since stepped in to fill that void, providing an important source of credit and further diversifying risk among a broader set of investors. Many of these newer entrants created more tailored products to the needs of private companies in need of credit.
The market for private debt is incredibly sophisticated and regulated by the Securities and Exchange Commission. These loans are carefully underwritten, and the lenders typically have skin in the game. In the case of private credit, firms (and, in many cases, the individuals who work for them) are putting their own capital at risk – because that is what investors require – so they care deeply about being paid back. If they don’t, they personally lose money.
This is long-term capital that is not governed by the same whims of the public debt market. Private credit funds have been in this market for decades and price this risk appropriately. Even regulators who have raised concerns about the recent growth in private debt acknowledge this lending does not pose a systemic threat to the entire economy.
There is a tendency to compare private market debt to some of the shakier products that caused the financial crisis, like mortgage-backed securities. But those comparisons are misleading. For starters, the financial crisis was driven in large measure by mortgage lending, a form of consumer debt. Most of the funds that own this debt are strictly forbidden from holding any kind of consumer credit, throwing cold water on the recent spate of rumors that this market is funding mortgage debt.
Federal Reserve Chairman Jerome Powell, Treasury Secretary Steven Mnuchin, and Securities and Exchange Commission Chairman Jay Clayton have all largely dismissed concerns that these private market loans pose a risk to the banking system.
Private lenders are sophisticated investors buying credit in businesses that know the markets in which they operate. Most of the managers who invest in these loans are looking to diversify a small slice of their portfolio. Unlike banks that borrow short and lend long, the assets in private credit funds match their liabilities. This means they don’t need to sell assets to generate liquidity when prices fall.
Private market debt would avoid that vicious cycle because lenders are well capitalized and largely isolated to the private market. Fed Chairman Powell acknowledged those benefits in a 2018 speech to the Economic Club of New York, telling the crowd that, in a downturn, most of the corporate loan losses would “fall on investors in vehicles like collateralized loan obligations with stable funding that presents little threat of damaging fire sales.”
Additionally, private credit funds generate solid returns for their investors with less volatility than other popular investing tools, including public equities.
According to PitchBook, through the first quarter of 2019, private credit funds generated average annual returns of nearly 7 percent over the preceding five years. Over that same period, private equity funds produced annual returns that were 13.5 percent, while the S&P 500 produced annual returns close to 11 percent.
The private credit market has been mischaracterized by some who do not fully understand it, as well as others who have a financial motivation to raise doubts about these investments. That is why it is important to establish what this market is – and what it isn’t – so investors understand the opportunities and risks and the public more broadly appreciates just how important these funding tools are for the small- and medium-sized businesses that power our economy.