ICYMI // Private Credit Fuels American Economic Growth

The two main sources of this capital are debt and equity. For much of the last century, banks have dominated the debt market by issuing traditional business loans, but increasingly, other entities have stepped in to supply that funding. One in particular has become a growing source of debt capital: private credit funds.

These long-term investment pools hold a diverse mix of debt, primarily issued by privately held companies that do not have access to the traditional debt market. The investment funds often provide businesses with capital when it is not otherwise available. Private credit funds held just $25 billion in 1999. That total grew to $800 billion in 2019, according to Hamilton Lane.

One reason for this growth is that banks no longer dominate the market for business lending like they used to. Banks have scaled back this activity over the last 30 years because of structural changes in the industry and because of regulatory changes that have created a disincentive to lend, such as higher liquidity requirements. This is particularly true for smaller and mid-sized companies that have a harder time securing a traditional loan or are not big enough to issue public equity or debt.

This retreat from traditional lenders has opened the door for private credit to fill the void in a way that is structurally safer for the broader economy, according to a new report by the American Investment Council.

The growth of the private debt market has spawned plenty of questions about the safety of these investment vehicles and their impact on the broader economy. The truth is that this market poses far less risk to the financial system because the funds are typically less exposed to market downturns and the investors have longer time horizons.

These funds are not interconnected. They use moderate leverage. Investors hold notes to maturity. And the funds are not forced to sell assets during a downturn. Private credit also pairs lenders with borrowers who have comparable risk appetites.

Because these funds are highly diverse, there is less risk that the failure of one loan obligation would trigger further losses in that fund or others managed by the same firm, much less other financial institutions. And unlike the financial instruments that triggered the last financial crisis, these funds are not concentrated in a single sector – residential real estate, for example.

Private credit funds are more resilient during periods of market volatility because they require investors to commit money for predetermined periods that can be as long as eight years. These lock-up periods shield private credit funds from the kind of runs that result when investors demand redemptions, allowing them to avoid selling assets when values plunge.

Private credit funds draw the overwhelming majority of their investments from sophisticated institutional investors who are looking for stable returns, risk mitigation and diversification. These credit funds generate yield for investors at a time when traditional fixed-income assets produce historically low interest rates, making them more attractive in the current low interest rate environment.

Private credit outperformed public credit in the 10 years that followed the Great Recession by a healthy margin, according to research by Hamilton Lane. But diversification is the main reason investors flock to these funds, according to a survey by Preqin. They are drawn to private credit because it is the asset class least correlated to public equity markets.

Many businesses choose to borrow money rather than issue stock because it allows them to retain ownership. In return, they have a fixed obligation to repay the lender at terms that do not fluctuate with the market. Many small and medium-sized businesses don’t have even have access to equity financing, so they depend on debt to grow and fund their day-to-day operations. The private credit market can offer a lifeline to businesses on the brink, stabilizing the broader economy by investing in companies that would otherwise contract or go bankrupt.

As a whole, private equity is far less reliant on borrowed capital than it was a decade and a half ago. Over the past 15 years, private equity firms use of debt declined significantly. Average loan-to-value on new investments was 53 percent in 2020, down from 68 percent in 2005.

Credit is critical for businesses to grow and to ensure a dynamic and growing economy. Private credit has become a growing and increasingly mainstream source of funding for a broadening array of corporate borrowers, particularly those with the least access to finance. It offers investors a path to achieve higher and diversified returns. And it increases the strength and resilience of the U.S. economy.