THERE ARE many ways to tell the story of the turnaround in America’s capital markets since last spring. The focus has been on public markets, notably the wondrous surge in share prices. Yet the change in fortunes of private equity (PE) is perhaps more remarkable. A year ago Blackstone, a PE giant, reported a first-quarter loss of more than $1bn. A reckoning seemed overdue. Widespread defaults on overborrowed PE-owned businesses were expected. A year on, Blackstone has reported record profits of $1.75bn. So much for comeuppance.
Its rude health owes a lot to the speed, as much as the extent, of recovery in asset prices. Buyout shops barely had time to mark down their portfolio companies in line with a falling stockmarket before share prices suddenly recovered. Dealmaking has picked up to a frantic pace. Competition from corporate buyers means that buyout firms must move quickly. Where they have an edge is in raising debt. In fact the premium on speed in PE is why you should expect to see a sharp pickup in a related corner of capital markets—private credit.
Private credit mainly serves mid-sized companies that are acquiring something or undergoing change of some kind—buying out a family member’s stake; refinancing their bank debts; and so on. More often than not, this change will be carried out under the auspices of a PE sponsor and require a lot of borrowing. Banks used to finance this sort of thing, but not anymore. To access the public markets, a company must meet the demands of regulators. It must be biggish and profitable, with a history of pristine financial statements. A lot of companies do not tick the boxes.
Private credit has elements of both bank and capital-market finance. It is like a bank loan in that it is tailored to the borrower and does not usually change hands in markets. It is like a publicly traded bond in that the end-investors are pension and insurance funds looking for regular fixed income. The border between private and public credit is blurry. The defining factor is how widely a loan is distributed. The highest-profile part of private credit is the market for leveraged loans, which are fixed-income instruments sold to syndicates of investors. The more widely a loan is distributed the more liquid it is. A broadly syndicated loan might be sold to 100 or more lenders. By contrast, the number of parties to a truly private deal is often in the single digits.
The bigger PE firms have private-credit arms. The set of skills required is similar, says Mike Arougheti of Ares, a private-asset manager. Both types of investor need to make sound judgments about the growth of cashflows, and the hazards around it, for companies that are not widely researched. There are obvious synergies. Say a PE firm has carried out due diligence on a buyout target only to lose out to a bid from a rival. Having done the homework, the losing firm might call up the winner and offer to buy the debt.
This nexus with PE is one reason to expect a spurt in private credit. For PE sponsors, the attraction of private credit is speed. There are no lengthy discussions with regulators, rating agencies or underwriting banks. And speed matters more than ever. Buyout funds have $1trn or more of “dry powder”, capital that has been raised but not yet deployed. “Equity markets have rallied, so corporate buyers are competitive,” say Mark Attanasio and Jean-Marc Chapus of Crescent Capital, a private-credit firm. The upshot is that every potential target has many bidders.
The other reason to expect growth in private credit is its appeal to investors. Yields are higher than on widely traded corporate bonds. Moreover, the interest charged on private loans is usually tied to short-term interest rates. That protects investors from sudden changes in Federal Reserve policy, which fixed-rate corporate bonds are vulnerable to. Private-credit specialists typically demand greater control over the terms of lending. That way they can mitigate the risks of a borrower getting into trouble. They are also better placed to recover more of their money in the event of a default. In a lightly syndicated deal, there are fewer people to indulge in wasteful squabbling over the remains.
Everything is happening more quickly in capital markets. Even though private markets do not trade minute-by-minute, there is little time to lose. It seems only yesterday that regulators were fretting publicly about the unchecked growth of opaque private-credit markets. Things then went quiet.But the noise levels may go up again soon.