Private Credit: Lending Outside the Banks

A company that needs to borrow has three main options:

• A bank loan, which the bank may keep or sell on to other investors (the "leveraged loan" market for riskier borrowers).
• A bond sold to many investors and traded publicly, rated by agencies such as Moody's and S&P. Larger companies use this route; see Credit and Spreads.
• A private loan negotiated directly with one fund or a small group of lenders, which keep it until it is repaid.

Private loans appeal to mid-sized companies, and to private equity firms buying them, because they can be agreed quickly, terms can be tailored, and nothing has to be disclosed publicly.

After the 2008 financial crisis, new rules required banks to hold more capital against risky loans, so many pulled back from lending to smaller and heavily indebted companies. Funds stepped into the gap. Years of near-zero interest rates then made the higher yields on private loans very attractive to pension funds, insurers and wealthy investors. Large asset managers and insurers have built big private credit businesses, and products for individual investors have followed.

The returns

A typical direct loan pays a floating rate, such as the SOFR short-term rate plus 5–7 percentage points. With short-term rates around 5% in 2023–24, that meant yields of roughly 10–12%, compared with about 5–6% on investment-grade corporate bonds. The extra return pays for illiquidity, higher default risk and less transparency.

• Rising rates hit borrowers directly. Because the loans float, interest bills rose sharply in 2022–23. Some borrowers switched to paying interest with more debt instead of cash ("payment in kind"), which analysts treat as a warning sign.
• Valuations are estimated, not traded. Funds value their loans themselves, usually quarterly. That makes returns look smoother than those of public bonds, which critics argue hides real swings in value.
• Liquidity mismatch. Funds that promise investors regular withdrawals while holding loans that can't easily be sold may have to limit withdrawals in a crisis.
• Links to banks. Banks lend to private credit funds, so stress in the funds can travel back into the banking system.
• Untested in a deep recession. The market grew mostly during a long expansion. How default rates and recoveries behave in a severe downturn is unknown.

Private credit now finances a large slice of mid-sized companies, especially those owned by private equity. When its lenders become cautious, those companies feel it first, through less available money and tougher terms, before it shows up in public bond markets. That is why the daily briefing watches fund flows, default rates and payment-in-kind usage as signs of credit conditions beyond the banks.