Investment Strategy

Can private credit continue to perform?

Sep 12, 2023

We think so—and see an unusual opportunity for investors as measures of risk decline, yet compensation, in the form of yield, goes up.

Thomas Kennedy, Chief Investment Strategist, J.P. Morgan Private Bank

Chris Seter, CFA®, Global Investment Strategist, J.P. Morgan Private Bank

Jay Serpe, Global Head of Alternative Investments Strategy & Business Development, J.P. Morgan Private Bank

Rachel Cascio, CFA®, Private Investments Due Diligence, 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:

Risk and loan size determine where a company borrows

Source: J.P. Morgan Private Bank; information as of August, 2023. 
This chart shows corporate lending sources along credit risk in the y-axis and loan size in the x-axis. Traditional bank loans occupy the less risky and smaller loan size portion of the chart. Corporate bonds fit within the larger size zone and span risk levels. Direct loans are higher risk and skew smaller but overlap with leveraged loans, which are higher risk and larger than direct loans.

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.

Leveraged debt (including private credit) has kept pace with profits

Aggregate leveraged borrowing vs. nonfin domestic corporate profits, indexed to 100 at YE 2009

Sources: BEA, J.P. Morgan, Preqin, J.P. Morgan Private Bank; data as of 4Q 2022. Leveraged borrowing: North American private credit excluding dry powder, JPM Leveraged Loan Index par value, JPM Domestic High Yield Index 
This chart compares domestic nonfinancial corporate profits and aggregate levered borrowing (equal to North American private credit AUM excluding dry powder, leveraged loans outstanding and high yield debt outstanding) both indexed to 100 in 2010. Each line has increased by about 150-175% since 2010.

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.

Recent direct loan deals yield about 300 basis points more than public markets

Source: J.P. Morgan; data as of July 31, 2023. *YTM includes original issue discount (OID).  At issuance private credit deals are issued at a discount to par value, which represents a fee paid from the lender to the issuer. 
The chart shows yields for JPM Loan Index and private credit new deals at transaction close. Private credit YTM has risen from about 7.5% in January of 2022 to about 12% in July 2023. JPM Loan Index YTM rose from about 6% in January of 2022 to about 9% in July 2023.
  • 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.

Leverage on new direct lending deals has declined

Net debt-to-EBITDA for new direct loan deals

Source: J.P. Morgan. Data as of June 2023. EBITDA = Earnings before interest, taxes, depreciation and amortization.
This shows issuer net leverage, or the ratio of net debt to EBITDA, for new private credit deals. It spent 2021 in the 5.5-6.5x range and has trended lower towards 4x as of mid-2023.
  • Protections for private credit lenders are robust and growingA 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.

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In Hong Kong, this material is distributed by JPMCB, Hong Kong branch. JPMCB, Hong Kong branch is regulated by the Hong Kong Monetary Authority and the Securities and Futures Commission of Hong Kong. In Hong Kong, we will cease to use your personal data for our marketing purposes without charge if you so request. In Singapore, this material is distributed by JPMCB, Singapore branch. JPMCB, Singapore branch is regulated by the Monetary Authority of Singapore. Dealing and advisory services and discretionary investment management services are provided to you by JPMCB, Hong Kong/Singapore branch (as notified to you). Banking and custody services are provided to you by JPMCB Singapore Branch. The contents of this document have not been reviewed by any regulatory authority in Hong Kong, Singapore or any other jurisdictions. You are advised to exercise caution in relation to this document. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. For materials which constitute product advertisement under the Securities and Futures Act and the Financial Advisers Act, this advertisement has not been reviewed by the Monetary Authority of Singapore. JPMorgan Chase Bank, N.A., a national banking association chartered under the laws of the United States, and as a body corporate, its shareholder’s liability is limited.

With respect to countries in Latin America, the distribution of this material may be restricted in certain jurisdictions. We may offer and/or sell to you securities or other financial instruments which may not be registered under, and are not the subject of a public offering under, the securities or other financial regulatory laws of your home country. Such securities or instruments are offered and/or sold to you on a private basis only. Any communication by us to you regarding such securities or instruments, including without limitation the delivery of a prospectus, term sheet or other offering document, is not intended by us as an offer to sell or a solicitation of an offer to buy any securities or instruments in any jurisdiction in which such an offer or a solicitation is unlawful. Furthermore, such securities or instruments may be subject to certain regulatory and/or contractual restrictions on subsequent transfer by you, and you are solely responsible for ascertaining and complying with such restrictions. To the extent this content makes reference to a fund, the Fund may not be publicly offered in any Latin American country, without previous registration of such fund’s securities in compliance with the laws of the corresponding jurisdiction.

JPMorgan Chase Bank, N.A. (JPMCBNA) (ABN 43 074 112 011/AFS Licence No: 238367) is regulated by the Australian Securities and Investment Commission and the Australian Prudential Regulation Authority. Material provided by JPMCBNA in Australia is to “wholesale clients” only. For the purposes of this paragraph the term “wholesale client” has the meaning given in section 761G of the Corporations Act 2001 (Cth). Please inform us if you are not a Wholesale Client now or if you cease to be a Wholesale Client at any time in the future.

JPMS is a registered foreign company (overseas) (ARBN 109293610) incorporated in Delaware, U.S.A. Under Australian financial services licensing requirements, carrying on a financial services business in Australia requires a financial service provider, such as J.P. Morgan Securities LLC (JPMS), to hold an Australian Financial Services Licence (AFSL), unless an exemption applies. JPMS is exempt from the requirement to hold an AFSL under the Corporations Act 2001 (Cth) (Act) in respect of financial services it provides to you, and is regulated by the SEC, FINRA and CFTC under U.S. laws, which differ from Australian laws. Material provided by JPMS in Australia is to “wholesale clients” only. The information provided in this material is not intended to be, and must not be, distributed or passed on, directly or indirectly, to any other class of persons in Australia. For the purposes of this paragraph the term “wholesale client” has the meaning given in section 761G of the Act. Please inform us immediately if you are not a Wholesale Client now or if you cease to be a Wholesale Client at any time in the future.

This material has not been prepared specifically for Australian investors. It:

  • May contain references to dollar amounts which are not Australian dollars;
  • May contain financial information which is not prepared in accordance with Australian law or practices;
  • May not address risks associated with investment in foreign currency denominated investments; and
  • Does not address Australian tax issues.

References to “J.P. Morgan” are to JPM, its subsidiaries and affiliates worldwide. “J.P. Morgan Private Bank” is the brand name for the private banking business conducted by JPM. This material is intended for your personal use and should not be circulated to or used by any other person, or duplicated for non-personal use, without our permission. If you have any questions or no longer wish to receive these communications, please contact your J.P. Morgan team.

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JPMorgan Chase Bank, N.A. and its affiliates (collectively "JPMCB") offer investment products, which may include bank-managed accounts and custody, as part of its trust and fiduciary services. Other investment products and services, such as brokerage and advisory accounts, are offered through J.P. Morgan Securities LLC ("JPMS"), a member of FINRA and SIPC. Insurance products are made available through Chase Insurance Agency, Inc. (CIA), a licensed insurance agency, doing business as Chase Insurance Agency Services, Inc. in Florida. JPMCB, JPMS and CIA are affiliated companies under the common control of JPMorgan Chase & Co. Products not available in all states. Please read the Legal Disclaimer in conjunction with these pages.

INVESTMENT AND INSURANCE PRODUCTS ARE: • NOT FDIC INSURED • NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY • NOT A DEPOSIT OR OTHER OBLIGATION OF, OR GUARANTEED BY, JPMORGAN CHASE BANK, N.A. OR ANY OF ITS AFFILIATES • SUBJECT TO INVESTMENT RISKS, INCLUDING POSSIBLE LOSS OF THE PRINCIPAL AMOUNT INVESTED

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