For decades, the 60-40 mix of stocks and bonds has been a broadly accepted tactic to balance risk and generate returns.
But, 2022’s volatile financial markets and this year’s challenging conditions in capital markets left many investors adhering to this strategy with losses in their equity and debt portfolios. As a result, investors and advisors seeking a safe haven from market volatility accelerated a shift to the rapidly growing and relatively stable private credit market that funds middle market businesses that generate 40% of U.S. GDP.
The use of private credit, which generally describes lending to private middle market companies by non-bank lenders, has risen dramatically over the past decade. The expansion of this asset class is largely driven by the swift retrenchment of regulated banks’ lending activities to middle market borrowers after the Great Recession. Over the last 12 years, non-bank lenders provided 72% of the loans to middle market businesses, up from 42% from 1997 to 2009, according to data compiled by PitchBook Data, Inc. Meanwhile, the amount allocated to private credit strategies by institutional investors rose from $512 billion in 2015 to $1.21 trillion in 2021, according to data provider Preqin, and this asset class is expected to have $2.69 trillion in assets under management by 2026.
While total assets allocated to private debt remain substantially less than those invested in private equity, the current growth rate of private debt is higher. Fund raising for private debt strategies rose 14%, while fund raising for private equity fell 7% and real estate fund raising plummeted 31% from 2021 to 2022.
For many investors, the attraction to private credit is its ability to deliver relative stability and offer attractive returns, particularly in a rising interest rate environment. While interest rates rose, the predominantly floating rate loans made by private credit providers generally held their value and provided a rising income profile. A 2021 survey of investors by Preqin found that 36% of the respondents were drawn to private credit because of its reliable income stream and 37% liked the high risk adjusted returns.
That said, private credit isn’t for everyone. Advisors will want to ensure that their clients understand the risks and carefully consider whether certain elements of private credit—such as illiquidity, the difficulty in evaluating individual investments or the distinct fee structures—are appropriate for individual portfolios.
The private credit market typically funds stable middle market businesses driving the U.S. economy in several core areas including manufacturing, business services, healthcare, information technology and financials. These businesses with $10 million to $2 billion in revenues account for $9 trillion of U.S. GDP and employ about one-third of the U.S. labor force, according to RSM, a middle market consulting services provider. In the first quarter of 2023, RSM’s Middle Market Business Index found that driving optimism among the 406 middle market senior executives polled for the survey were increases in revenues and earnings for Q1 2023 and slowing inflation. Over half of those executives (57%) expected to see an increase in both gross revenues and net earnings through the middle of the year.
While some of the deepest stomach-churning losses in equity markets in 2022 have been erased, financial markets volatility as measured by the VIX Index remains elevated, in part due to the current banking turmoil. Investors will likely continue to see challenges to global growth that weigh on balance sheets and impact earnings for some time to come. For those who want to minimize their exposure to the sharp moves in public equity prices and bond yields, financing of middle market businesses through Private Credit funds may be a viable option.
Dean D’Angelo is the founder and a partner at Stellus Capital Management, a Houston-based private equity firm with $2.8 billion in assets under management that specializes in private debt financings of middle market businesses.