26 Aug Where Is Private Credit Going… and Why Should Entrepreneurs Care?

Another installment of “Adventures in Entrepreneurism” brought to you by Pasadena Private Lending President Mike McAdams

Besides helping start PPL and six other financial businesses throughout my career, back in 1989 I was a very early investor in larger, corporate, senior-secured, floating-rate loans for retail as well as for institutional investors. Such loans were typically from $500 million to $1 billion or more. I can’t emphasize how important to the growth of the market it was to clearly explain the differential merits of those loans’ income and return patterns vs. any other type of fixed income instruments.

That is, it was necessary to clearly explain to people the return and risk profiles of so-called broadly syndicated loans (or BSLs) as opposed to investment grade and non-investment grade corporate bonds, mortgages, emerging market debt, muni’s and almost every other type of income-generating investment. In retrospect, it was like trying to describe the merits of an Apple iPhone in 2007 but getting the response, “I have things that do most of that already. Thankfully, people realized the inherent advantages of BSLs (and, of course, smart phones). Demand grew, the demand begat supply, and that market is now in excess of $1 trillion dollars.

The problem is, growth of all small businesses and even industries can have costs. Today, the BSL market is liquid, transparent, and still generating higher floating rate income (without the values of the loans being impacted by changes in the levels of government rates). However, quality has fallen as managers striving to get fully invested have accepted lower quality loans with lesser collateral and few if any covenant or other legal protections. As a result, historic 2% default rates and 80-85% recoveries have fallen to 4% defaults with 60% recoveries.

Since the global financial crises of 2007-2008, the growth of non-bank lenders has multiplied in the U.S. middle market, defined as “smaller than the BSL market” borrowers. Many of those borrowers’ needs can be addressed by the larger private lending shops and their ability to raise capital sized to make a portfolio of $100-500 million loans. If they team up with other similar lenders, they can compete with large banks. As a result, borrowers have found those non-bank shops attractive and speedy for reasons we have often discussed in other PPL Private Credit Insights articles. However, the same evolving liquidity and investment demand may be happening in this so-called “large club,” middle market loan sector. So while the so-called “golden age of private lending” has been fueled by investors shifting from BSL to middle market, at least to date, history tells us that excesses always breed errors.

Over the next few years, if history continues to repeat itself, we could see similar demand for higher yielding, well underwritten, and thus less correlated LOWER middle market senior loans, PPL’s lending focus. While lower middle market loans have the disadvantage of less transparency and the image of being under-capitalized firms, PPL does significant due diligence on all its borrowers, and we allow significantly less leverage than BSL and upper middle market transactions, plus we require owner personal guarantees.

While it is too early to say when the upper middle market will exhibit stresses as the BSL market has, as one of very few non-bank lenders focused on the lower end of the middle market spectrum, I can confidently say we do not have any pressure to find transactions to meet budgets nor do we see competition that compels a response. We do see data services trying to collect information on lower middle market borrowers to create an index of sorts, but being private companies, their efforts have been minimally successful.

So to answer the question in the title of this article, based on my 30+ years of experience, private credit for the smaller middle market has many years left of providing prompt, responsive, creative financing to smaller corporations. While larger borrower markets have become highly competitive, some to a fault, the niche small middle market lenders fill is likely to progress for some time with little external pressure.

If there were any developments that could alter that conclusion, it would be an increase in the number of private companies willing to share proprietary information with the marketplace to create indices and statistical and yield comparisons. At some point, we might expect to see some attempts at regulatory restraints. But all that is likely years, perhaps decades, away.

This article was prompted by a LinkedIn post by Marc Andrews. It and McAdams’ response may be found by clicking here.