Private credit opportunities 2024
2023’s European and regional US banking crisis put regulators back on the case of raising banks’ capital requirements. Alternative lenders again stand to potentially benefit.
Key takeaways
Unregulated providers of capital benefit when regulations hamper traditional low-cost providers (banks), and this is an investable trend.
One can step in as the alternative lender through private credit funds to potentially generate yield premiums over traditional securities.
Or for qualified investors, invest in the managers via listed alternatives firms or private general partner (GP) stakes funds.
More regulation for banks
US regulators recently proposed a comprehensive series of reforms designed to mitigate risk in the banking sector. Bank executives have expressed concern that the proposed rules – which would increase large-bank capital requirements by as much as 16% and enforce more consistent risk management standards – will have a negative impact on the banking industry. In the process, the executives say, the changes will push traditional banking services such as middle-market corporate lending to non-bank financial firms, potentially benefitting their investors.
Since the global financial crisis, systemically important banks have contended with wave after wave of higher regulatory capital requirements. The latest proposed increases are still just that: proposals. Still, the banks’ response (primarily focused on limiting the impact on consumer lending and other specific business lines) suggests that an additional capital burden is all but inevitable.
The beneficiaries: alternative investment managers and funds
Negative trends for one sector can be a tailwind for another. That’s why we see increased regulation today as a boost for non-bank capital providers tomorrow. This is especially true for alternative investment managers, who have seen their businesses grow faster and more profitably as bank regulatory requirements have constrained their competitors.
From 2000 to 2022, alternatives assets under management (AUM) grew at a 12.6% compound annual growth rate (CAGR) to $16 trillion and are expected to reach $23.3 trillion by the end of 2027 (Figure 1).1 Private credit, a subset of private equity, has been a key component of that growth, growing twelve-fold between 2006 and 2022.2 In all, non-bank lenders today represent 83% of the $12.8 trillion non-real estate corporate lending market in the US.3
Figure 1: Growth in alternatives AUM 2000-2022
Source: Preqin and HFRI as of December 31, 2022
Three ways to invest in private credit
We see several ways for qualified investors to take advantage of the continued growth of US and European private credit and other non-bank lending.
The most direct way is to invest in a private credit fund. Already, there is a growing imbalance between the demand for private capital and the capacity of the private credit system to provide it. Private capital providers are able to charge a premium in this environment and pass that on to their investors in the form of higher yields. For investors with the liquidity to accommodate extended lockup periods, these vehicles may deliver a potentially attractive source of yield today. As of early November, direct lending was generating a premium of 276 basis points over comparable-risk leveraged loan funds and a 493 basis point premium over high-yield corporate bonds.4
Another option that investors often don’t consider is to buy stock in the large publicly traded private equity firms that manage private credit funds. After all, buying stock in the managers allows an investor to benefit from three income streams underpinned by assets under management growth: underlying investment returns (as the manager has a general partner interest in each fund it manages), management fees and performance fees (i.e., “carried interest”). A diversified portfolio of alternative investment businesses is another reason to consider these shares. Many of these companies have other divisions that could benefit from cheaper financing when rates eventually head lower.
Finally, there’s also another avenue to participating in the disintermediation of the banking sector: the ownership of general partnership interests, or “GP stakes,” in alternative managers. A General Partner (GP) stakes fund acquires a series of minority interests in private equity/private credit managers. When there is an investment in the fund, therefore, receiving a fractional ownership in each of the managers as well as a sliver of the general partnership stake the manager owns in each of its underlying deals. This provides exposure to all three revenue streams, but also to a broader range of managers (including non-publicly listed ones) than one would get from owning only publicly traded companies.
Owning a GP stakes fund provides direct exposure to the underlying deals as one would get from investing in a private credit fund, but with the added benefit of sharing in management fees and carried interest revenues. There is also the potential benefit of better tax treatment befitting a fractional GP status. So, instead of being taxed as income, all the revenue exposure is currently taxed at the (much lower) capital gains rate, thanks to the special considerations in the tax code regarding a general partner’s carried interest. Generally speaking, one’s tax liability should be discussed with a tax and/or legal advisor prior to seeking this opportunity.
Regulatory risk for non-banks is not completely off the table
The growth in the US private credit system could attract the scrutiny of regulators. But we don’t think that is imminent.
Our reasons are twofold. First, the asset/liability mix for non-financials is materially different. For banks, public depositors are “at risk” given that short-term deposits are used to fund longer-term lending. For alternative firms, capital is raised from institutions and wealthier individuals in segregated vehicles that limit broad contagion in the event of failure.
Second, regulators have repeatedly shown that while they recognize the potential for risk to build up in the so-called shadow banking sector, their primary priority remains systemic risk. The recent slump in commercial real estate is the latest example of this. As some real estate private equity funds found themselves under water in 2022, and their investors waited out lengthy redemption delays, regulators focused most of their attention on curbing the issuance of commercial mortgage-backed securities which are underwritten and often held on the balance sheets of the large, systemically important banks.
We believe the immediate risk for alternative managers is the tax reclassification of some of their profits from capital gains to ordinary income. As noted, the managers presently receive preferential treatment, but that has come under scrutiny as legislators seek new sources of income.
As banks continue to face new regulatory challenges to their businesses, unregulated financial firms remain ready to step in to meet demand and fill the void. The shadow banking system is not without its own stresses and risks. And over time we expect regulation may well increase. But for now, there should be a good runway for continued growth accessible through the three strategies presented.
Before considering these strategies, qualified investors should consider their investment objectives, risk tolerances and liquidity profile. The strategies discussed can be speculative and entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in the fund, potential lack of diversification, absence of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation, higher fees than mutual funds and advisor risk.
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