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Setting the stage

Credit markets used to be relatively straightforward. Most credit assets originated as either bank loans or bonds. Banks played a central role in lending, holding loans on their balance sheets. This simplicity provided a predictable landscape for institutional investors who might, for example, participate in syndicated deals.

In the early 2000s, financial innovation, regulatory changes to capital requirements, and the search for higher returns introduced complex instruments like CLOs and securitizations. 

Global private debt assets under management have risen by over 50%, reaching over $1.6 trillion in 2023. According to Preqin, these assets are projected to grow further, potentially hitting $2.8 trillion by 2028, with an estimated annual growth rate of 11%.1

We are now in the midst of a new paradigm shift, driven by the rise of private lending. Direct loans generate returns through interest and fees. These loans are also becoming part of the credit asset supply, feeding into more complex instruments just as loans did in the first wave.

The impact of non-bank lenders

After the 2008 financial crisis, the resulting regulatory environment paved the way for non-bank financial institutions, including private equity firms, direct lenders, and alternative asset managers, to fill a void. Because non-bank lenders are not bound by the same stringent regulations, they can offer more flexible and customized lending solutions.

On the one hand, this flexibility provides capital to a broader range of companies, including those with higher risk profiles. This shift has helped the supply of private credit assets surge, making them a crucial part of the financial landscape. On the other hand, this lending activity is diversifying the credit landscape and has sparked interest in developing secondary markets for these loans.

Development of secondary markets for private credit

Traditionally, private credit loans have been seen as illiquid investments, with lenders often holding them until maturity. However, the rising demand for liquidity and the maturation of the private credit market have led to the creation of secondary markets.

Secondary markets for private credit loans bring several benefits:

  • Liquidity: They can transform private credit loans from illiquid assets into more liquid ones, making them more attractive to a broader range of investors.
  • Price discovery: Trading in secondary markets improves price discovery, offering more transparency and supporting smarter investment choices.
  • Risk profile: Kroll Bond Rating Agency Index of Direct Lending Deals (KBRA DLD) showed a trailing 12-month default rate of 2% for direct lending (as of Q1 2024)2 versus a training default rate (as of April 2024) of 4.51% for syndicated loans.3
  • Risk management: The ability to trade loans in a secondary market allows lenders to better manage their risk exposure. They can sell loans that no longer fit their investment criteria, thereby optimizing their portfolios.

Potential challenges for secondary markets

The bespoke nature of many private credit loans, often tailored to specific borrower needs, can make standardization and valuation difficult. Additionally, the growing prominence of private loans in the credit market has several significant implications for competition, credit risk, borrower dynamics, and regulatory oversight.

Increased competition and pressure on lending rates

As private credit markets grow, competition among lenders has strengthened. Non-bank lenders, with their flexibility and fewer regulations, are giving traditional banks a run for their money. But the pressure to deploy capital has sometimes resulted in weaker underwriting standards and looser covenants, raising concerns about the potential for increased default rates and financial instability in a downturn.

Shift in credit risk

The migration of credit risk from banks to private funds also raises the specter of systemic risks. With the rise of private credit, risk is dispersed among a diverse group of private equity firms, direct lenders, and other non-bank financial institutions. As a result, it could become harder to see where potential problems might be brewing, raising concern among financial regulators. Institutional investors therefore need to step up their risk assessment and management skills to navigate successfully.

Smaller companies accessing private credit often benefit from more flexible terms and customized financing solutions unavailable through traditional bank loans. However, these benefits come with higher leverage and greater vulnerability to economic fluctuations and rising interest rates. The ease of access to private credit can encourage borrowers to take on more debt than they would otherwise, potentially leading to financial distress if market conditions deteriorate. Institutional investors must consider these factors when evaluating the risk-return profile of private credit investments.

Regulatory concerns

The rapid growth of private credit has caught the attention of regulators seeking enhanced oversight and transparency. They have expressed concern about the opaque and interconnected nature of the private credit market and the threat of significant systemic risks. If non-bank lenders fail, the shockwaves could unsettle the broader financial system. One likely outcome would be for regulatory authorities to enhance reporting standards. Creating clear rules to make sure private credit markets run smoothly and openly is vital to preventing potential disruptions. We are watching potential developments closely.

Implications for market participants

The changing supply of credit assets has far-reaching implications for various market participants, particularly in risk management, liquidity, and administrative workloads.

Risk management and liquidity considerations

Institutional investors must vigilantly monitor borrower creditworthiness and market conditions to mitigate potential risks. As private credit grows, so does the need for robust frameworks that can handle the unique challenges posed by these assets. In addition, emerging secondary markets for private credit assets could improve liquidity and make assets more attractive to a broader range of investors. Lower risk premiums and greater flexibility could create a virtuous cycle of product innovation and increased trading.

Administrative workloads

Support providers for loan issuance and administration also face increased complexity, requiring advanced expertise and resources. The growth of private credit and the development of secondary markets add layers of administrative tasks, from detailed due diligence to ongoing monitoring and reporting. This increased workload necessitates a higher level of coordination and efficiency, driving the need for better tools and technologies to streamline operations.

How trustee and agent activities evolve

From our vantage point as trustees and agents, navigating the evolving credit landscape demands agility and strategic foresight. Trustees and agents play a critical role in ensuring that credit agreements are adhered to and that the interests of all parties are protected. That means the shift towards private credit and the emergence of secondary markets compels trustees and agents to be more proactive in managing relationships, understanding market trends, and anticipating potential issues. This ability to adapt to these changes will be crucial in maintaining the smooth functioning of credit markets.

Moreover, the evolving landscape of private credit and secondary markets presents numerous strategic opportunities for loan agents and trustees to diversify their offerings, form strategic partnerships, and leverage technology to streamline operations.

chart with different opportunities for loan agents to diversify offerings

Conclusion

The credit market is undergoing significant transformation, presenting both challenges and opportunities. Adapting to these changes is crucial for institutional investors seeking to navigate the evolving landscape successfully. Market participants should proactively address challenges and leverage opportunities to stay ahead in this dynamic credit market.

In addition, trustees and agents can play an important role in sustaining growth and stability by embracing diversification, forming strategic partnerships, providing advisory services, and leveraging innovative technologies. The future of credit markets will belong to those who are agile, informed, and ready to seize emerging opportunities while effectively managing risks.

Please reach out to discuss how we can support you with private loan transactions in this evolving market.

[1] Institutional investors expand private debt holdings despite growing competition. Ada Tabano, Benefits and Pensions Monitor, January 5, 2024.

[2] “Direct Lending Returns, Default Rates Improve in 1Q24,” LSTA, 12 June 2024. Link: https://www.lsta.org/news-resources/direct-lending-returns-default-rates-improve-in-1q24/

[3] “U.S. Distressed and Default Monitor: May 2024,” Fitch Ratings, 30 May 2024. Link: https://www.fitchratings.com/research/corporate-finance/us-distressed-default-monitor-may-2024-30-05-2024

Wilmington Trust’s domestic and international affiliates provide trust and agency services associated with restructurings and supporting companies through distressed situations.

Not all services are available through every domestic and international affiliate or in all jurisdictions. Services are available only to institutional clients, (i.e. Eligible Counterparties or Professional Clients as defined by applicable regulations), and not for Retail clients.

This article is intended to provide general information only and is not intended to provide specific investment, legal, tax, or accounting advice for any individual. Before acting on any information included in this article you should consult with your professional adviser or attorney. Facts and views presented in this report have not been reviewed by, and may not reflect information known to, or the opinions of professionals in other business areas of Wilmington Trust or M&T Bank. M&T Bank and Wilmington Trust have established information barriers between their various business groups.

 

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