We think so—and see an unusual opportunity for investors as measures of risk decline, yet compensation, in the form of yield, goes up.
Chris Seter, CFA®, Global Investment Strategist, J.P. Morgan Private Bank
What do you know about private credit—loans and other credit that is extended by an asset manager (rather than a bank) to corporate borrowers—that’s not usually tradeable?
Private credit, generally in the “alternative investment” category, has significantly outperformed traditional fixed income in recent years. Flows into the market have been equally strong.
Indeed, private credit is one of our high-conviction investment ideas, especially the sub-strategy direct lending. On the investment risk spectrum, private credit might be thought of as lying between equity and riskier types of fixed income. We think it could benefit from the recent turmoil in regional banking, and from a dynamic in which traditional lenders are backing away from this type of lending.
Still, some of our clients have expressed concerns about this asset class. They wonder: Has the private credit market grown too rapidly? (Metrics suggest it hasn’t.) Is its strong performance sustainable? We think so—particularly in direct lending, for four main reasons:
- Direct lending isn’t new. It’s traditional bank lending, but now taken up by asset managers.
- We disagree with the argument that rapid growth of private credit assets under management suggests exuberance: Direct lending is not adding meaningful corporate leverage overall, but taking market share from other loan sources.
- J.P. Morgan Asset Management’s 2023 Long-Term Capital Market Assumptions (LTCMAs) show forward-looking total returns for direct lending at 8% over a 10–15 year horizon.1 Current market dynamics suggest that could understate the current opportunity.
- We think the market offers investors adequate compensation for the risks.
Let’s dig into the details.
Direct lending is nothing new
In Reminiscences of a Stock Operator,2 still a popular book among traders after 100 years, the main character, who shorts the stock market before the crash of 1929, famously says, “There is nothing new in Wall Street…. Whatever happens [today] has happened before and will happen again.”
That truism resonates with us as we look at the evolution of direct lending. While direct lending may seem like a new asset class, it has actually persisted through multiple economic and market regimes. There is little new in corporate borrowing, though the lender is in these cases now an asset manager rather than a bank.
How direct lending fits into the spectrum of corporate debt
Corporate borrowers generally have four sources when they want to raise debt. A company’s size and creditworthiness generally determine where it goes to borrow:
Banks. Banks for hundreds of years have made loans to businesses of all sizes. Banks can hold loans on their balance sheets. Historically, bank lending has skewed toward smaller businesses and less risky borrowers.
Syndicated (leveraged) loans. Banks can also originate loans for the broadly syndicated loan (also known as the leveraged loan) market. The lenders sell the loans to other investors—they’re tradeable securities. (The leveraged loan market is most akin to direct lending, but there are important differences that we’ll get to.)
The bond market. Firms with large borrowing needs can tap the corporate bond market and publicly issue fixed rate debt (typically unsecured by collateral). Bonds, of course, are tradeable.
Direct lending. Direct lending describes loans that are usually made to small or medium-sized (“lower middle market”) businesses by asset management funds using capital they’ve raised from investors. The loans are private and generally not tradeable, but are held on the fund’s balance sheet until they are refinanced or mature.3
In sum: For companies that need financing, direct lending is now a well-established option.
The people behind many of today’s direct loans make the point that there is nothing new on Wall Street: As direct lending assets under management (AUM) have grown, lending specialist talent has migrated from banks to asset managers. Chief executives at nine of the 10 largest direct lenders all at one point worked in traditional bank lending.
What’s behind the shift from banks and syndicates to direct lenders?
Both a push and a pull help explain the rise in lending activity (and the move of loan talent) from banks to direct lenders.
U.S. bank regulation, passed in the wake of the global financial crisis (GFC), pushed banks away from lending by raising the amount of capital banks were required to hold if they made loans considered riskier.
Since then, during times of dislocation, traditional lenders’ pullback has accelerated. The recent bout of regional bank stress presented direct lenders with a new opportunity to take even more share from banks as lending standards tightened again.
On the pull side, direct loans are a bespoke lending product, and their customization makes them attractive both to borrowers and investors.
Borrowers are willing to pay more for simpler, confidential bilateral negotiations in which they need to release private financial and operational details to only one, or a few, lenders, and that’s important to some borrowers for the certainty that the loan will be executed, even in times of stress, and finally for speed. The timeline for issuance is cut from months to weeks.
Investors can potentially earn higher yields, and benefit from more restrictive underwriting, and terms and conditions (known as covenants) offering lender protection.
Putting the rapid growth of private credit AUM in context
We disagree with the argument that rapid private credit AUM growth is suggestive of exuberance. Total leveraged financial borrowing has merely kept pace with the growth of corporate profits. Direct lending is not adding meaningful corporate leverage overall, but taking market share from other loan sources.
There’s also widespread misunderstanding of the market’s actual size. Global private credit AUM hit $1.5 trillion in 2022 .4 However, despite frequent claims, this is not evidence that private credit has surpassed the high yield (HY) and leveraged loan markets.
The $1.5 trillion figure is not outstanding issuance, but rather a global total that includes dry powder (uninvested capital). In North America, private credit AUM excluding dry powder totaled $630 billion in 2022—below the current $1 trillion in outstanding U.S. HY and half the size of the $1.4 trillion in leveraged loans.5
The private credit market’s growth rate has accelerated recently, from a 12% average annual growth between 2010 and 2019 to 23% annual growth from 2020 to 2022.6 But that growth has taken market share from the HY and leveraged loan markets, rather than adding leverage to the economy. Aggregate leveraged finance lending7 has more or less kept pace with economy-wide corporate profits, outside the financial sector.
Total return8 expectations for direct lending may be understated
We see strong signals that direct lending’s performance over comparable credit instruments is likely to continue.
How much performance? Over the past 10 years (through 2022), private credit, tracked by the Cliffwater Direct Lending Index–Senior Only,9 has returned 7.8%, on average, versus 4.1% for the J.P. Morgan Leveraged Loan Index, its closest comparison. HY bonds (J.P. Morgan Domestic HY Index) returned 4.4%, on average, over the period.
As of 1Q 2023, direct lending yields averaged 10.6%, 1.5% over the average yield of the benchmark leveraged loan index. We’ll discuss future prospects in a moment. First, here’s why the direct lending yield is higher than leveraged loans right now—and we note that these are embedded characteristics of the market that aren’t likely going away anytime soon:
- Direct loans’ bespoke nature means lenders can, in bilateral negotiations, ask for more, and borrowers are willing to pay because of the loans’ speed, privacy and certainty of execution.
- The market’s skew toward smaller borrowers (compared to the leveraged loan market) means it’s considered riskier, allowing for a potential yield premium.
- Direct loans’ illiquidity—they are generally not tradeable—also helps explain the spread (yield compensation beyond other debt securities (or: “yield over that of Treasury bonds”?).
Why we think investors should consider private credit now
We think investors should look at private credit now because the market offers adequate compensation for the risk. To make this case, we’ll turn to proprietary data available within our firm.
As the business cycle rolls forward and market participants continue their obsession with the timing and depth of a potential recession, it’s natural to wonder about borrower defaults. We are monitoring this risk very closely, aware that higher rates historically equate to rising credit risk.
But what matters most when defaults have the potential to rise? Along with skilled asset managers, we believe it’s crucial to consider considering whether an investor is being adequately compensated for taking a particular risk at a given moment in time. We think direct lending investors are being adequately compensated.
By definition, private credit data is opaque because it is private. However, a luxury of working at J.P. Morgan is our scope: Our Investment Bank is one of the largest providers of leverage to direct lending asset managers, and its proprietary data gives us unique insights.
The J.P. Morgan Investment Bank Private Credit Financing Team sees about half of all direct lending deal flow. Being privy to most private credit deal terms, the team also has visibility into borrowing businesses’ fundamentals. As yields (compensation for risk) have risen meaningfully this year-to-date (YTD), this data shows that measures of risk have declined.
Here’s what we learned from the financing pipeline.
- Direct lending yields are up this year even as risk measures are down. The average direct loan YTD that the team saw yielded 12.5%—roughly 300 basis points more than the J.P. Morgan BB/B Leveraged Loan Index, which yielded 9.5%. That relationship (or “spread” between them) is a reversal of late-2021 to mid-2022, a period of direct lending10 that expert investors are worried about. (From late-2021 to mid-2022, measures of borrower risk were often worse than today’s, yet with so much low interest funding sloshing around, many companies could still borrow for less.)
Now that dynamic is gone. Instead, despite the noted acceleration in AUM growth, investors are getting more compensation—for loans to companies with superior risk metrics.
- The risk profiles of companies that the team has seen are better in 2023 than they were in 2022. This signals that direct lending asset managers are not chasing riskier loans.
Interestingly, the team found aggregate leverage in new deals declined in 2023, suggesting credit quality is improving while yield (compensation to investors for risk) increases.
J.P. Morgan proprietary financing data also shows that leverage in the direct lending market peaked in late 2021 and early 2022—another signal that this vintage is worrisome and most at risk of credit loss.
- Protections for private credit lenders are robust and growing. A large majority of the companies J.P. Morgan’s Financing Team has seen have rules in place that help protect lenders.11
Contrast that with the leveraged loan market, where nearly 80% of new leveraged loan deals this YTD have been “covenant lite,” a term that means there’s less protection for lenders. More than half of direct lending deals also included an “equity cushion” that protects the lender/investor against loss in the event of default: Equity would need to be wiped out before a direct lender is impaired.12
In sum: These are the makings of a safer lending environment.
Direct lending yield, in the new deal market today, is about 12%. The firm’s most recent LTCMAs (to be updated in October) show forward-looking returns for direct loans over the next 10–15 years would be 7.8%.13 That return is almost five percentage points below the current market, even as leverage and other risks have gone down.
Given the risk mitigation we’ve covered, we consider this a good risk-reward14—and a strong opportunity for investors today.
Speak with your J.P. Morgan team to explore whether investing in private credit would support your long-term financial goals.
1J.P. Morgan Asset Management’s 2023 Long Term Capital Market Assumptions as of 12/31/22.
2By Edwin Lefevre, first published in 1923.
3This type of lending is often done by a business development company (BDC), a type of publicly traded investment firm created by a 1980 act of Congress, focused on lending to lower-middle market borrowers—companies with median earnings of $75 million as of December 2022—by comparison, the leveraged loan market serves larger companies, on average: those with about $500 million in earnings as of December 2022, according to J.P. Morgan Securities. Data as of March 31, 2023.
4Source: Preqin, 3Q 2022
5Source: J.P. Morgan DataQuery as of 2023
6Source: J.P. Morgan DataQuery as of 2023
7Leveraged finance lending encompasses private credit AUM excluding dry powder, HY loans outstanding and leveraged loans outstanding. (We note that direct lending often includes the asset manager/fund adding modest amounts of leverage at the fund level, but direct lending should not be confused with leveraged loans.)
8Like any fixed income asset, direct lending total returns are a function of income and price changes. Income is driven by how much the borrower pays, along with modest leverage added by the fund seeking to amplify direct lending returns. (Despite the addition of leverage and the similar sounding terms, direct lending should not be confused with leveraged loans). Fees also have an impact on income. Price changes result when a company defaults on its loan, or is perceived to have a higher risk of default. Since the loans are floating-rate, duration is very low, which means changes in yield have a limited impact on price.
9Senior loans are part of what’s known as a company’s “capital stack” financing the company. Senior loans are first in line for repayment; other types of debt (such as junior) are lower in priority.
10Loans from a certain year are called a “vintage.”
11Called financial maintenance covenants, they cover aspects such as maximum leverage ratios, keeping a borrower from becoming overly indebted.
12Over half our J.P. Morgan direct lending financing deals in 2022 were for leveraged buyouts (LBOs), and they had an average equity cushion of nearly 60%. An equity cushion represents how a corporate borrower finances itself, and all else equal, the higher the equity cushion, the less likely a direct lender will be impaired. In 2023, equity cushions have increased further.
13J.P. Morgan Asset Management’s 2023 Long Term Capital Market Assumptions as of 12/31/22.
14In a severely adverse scenario such as a global financial crisis–like event in which credit losses mounted to 7%, total return could turn negative. However, we assign a low probability to a macro event of that magnitude.