Understanding the Evolution of Private Credit
Private Credit – Core and Lower Middle Market value proposition.
Recently, CNBC’s David Faber interviewed Apollo Global CEO Marc Rowan to discuss the increased amount of capital being deployed to private credit and how that, in addition to the re-emergence of investment banks, has started to change the landscape and alter where the alpha is being generated within the asset class. The emergence of private credit is altering the value proposition for investment-grade and higher quality high-yield bonds. Rowan stated: “We are witnessing a shift where institutions are moving away from traditional public alternatives and increasingly favoring private origination, while investors are gravitating towards private credit as public fixed income has become dominated by beta, with limited excess returns per unit of risk.” This holds true, of course, with the ICE BofA US BB High Yield index spread trading at 193 basis points over U.S. Government Bonds as of October 1, 2024. (citation 1) and the ICE BofA US BBB Investment Grade Index spread trading at 116 basis points over U.S. Government Bonds as of October 1,2024.
Public to Private Market Shifts
The differences between public and private markets — whether in terms of issuers, ratings, sizes, or liquidity — are narrowing. Though banks are re-entering the lending markets, increased government regulation may curtail the breadth of business they used to dominate, especially in the lower middle market. Furthermore, issuers are placing a premium on the speed and certainty of execution that private credit funds provide. Competition for these loans is increasing, especially at the upper end of the market. Large private credit firms are building their own origination platforms across various segments such as aircraft finance, inventory loans, and fleet refinancing to originate and scale new opportunities previously dominated by the public markets. Finally, the shift toward single-lender origination by these large private-credit funds has allowed them to take down entire issues, diversifying the risk across multiple entities.
Compression of Spreads
As more money flows into private credit, the compression of spreads between public and private markets could deteriorate significantly to the point where the liquidity discount would eventually become negligible. However, this compression will most likely be seen at the higher end of the market as large Private Credit funds need large loans against which to allocate their growing pools of capital. The smaller loan size at the lower end of the market should keep the supply-demand dynamic on the side of lenders, at least for the time being.
Challenges for New Entrants in the Middle Market
The evolution of Private Credit markets has naturally led to concerns about new entrants. Yes, there will be established funds entering the core middle-market space, but it is more likely to be driven by spinouts from larger entities that have relatively lower AUM, enabling returns that move the needle. The lower middle market, however, poses significant hurdles for new entrants.
At Ballast Rock Private Wealth, our competitive advantage is our ability to gain access to and select managers with proven underwriting standards, robust risk management capabilities, and success over multiple economic cycles. While new players will eventually emerge in the core middle-market space, the established, trusted lenders who have a history of navigating this niche market will continue to be the preferred partners. These lenders often enjoy the "right of first refusal" status, thanks to their track record, sponsor relationships, and long-standing experience. For new entrants, the vast majority of deals may originate from issuers that our partners prefer not to lend to, highlighting the importance of experience and caution in underwriting standards.
New entrants may often underwrite a higher proportion of deals simply to deploy capital and establish their presence. This approach can lead to higher instances of delinquencies and defaults, especially in cases where covenants are confusing or too lenient—often tripping up companies unaware of the risks involved. By contrast, our partners prioritize long-term relationships and transparency, focusing on quality over speed of deployment.
The Landscape of Private Credit Going Forward
The notion that Private Credit is inherently risky or limited to certain company sizes is evolving. We are at the beginning of a process where the traditional products available today may not exist in the next 10 to 15 years. Trading capital is now only 10% of what it was in 2008, and the lack of liquidity in public markets is prompting more focus on private origination.
Private Credit funds working directly with companies to solve specific capital needs is a clear signal of where excess returns will be found moving forward. While large firms continue to expand into private credit, Ballast Rock Private Wealth chooses preferred Private Credit managers for their selectivity, diversification, and established relationships in the middle market. This approach helps to ensure that our clients benefit from high-quality investments with strong risk-adjusted returns.
Please discuss with your financial advisor how the recent volatility might be affecting your individual portfolio. Email us at ir@ballastrockpw.com.
Citations:
1- ICE BofA BB US High Yield Index Spread (US Federal Reserve Bank of St. Louis)
2- ICE BofA BBB US Corporate Index Spread (US Federal Reserve Bank of St. Louis)