The Evolution of Private Credit: Part 2 - [Business Breakdowns, EP.164]

This Issue at a Glance

Josh Clarkson (Managing Director, Prosek Partners) deconstructs the private credit market in this podcast from four dimensions: industry history, structural design, leverage mechanisms, and interest rate environment. The core argument is: Private credit and the banking system are a symbiotic relationship with more cooperation than competition. BDCs (Business Development Companies), through statutory leverage limits and professional asset management, keep systemic risk far below the level that the market generally fears.

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Banks vs Private Credit: Deep Cooperation Beneath the Surface of Competition

Josh Clarkson argues that the competition between banks and private credit is limited to individual transactions, while the broader ecosystem reflects an evolving partnership, embodied in three models: leveraged finance, credit risk transfer (SRT), and joint venture platforms.

• Leveraged Finance: Most private credit funds (especially direct lending) use 0.75–1.5x leverage, and banks are typically the preferred providers of that leverage. The loans provided by banks are secured by a diversified, professionally managed asset pool within the fund and sit in a senior position. Banks themselves operate with roughly 10x leverage, while private credit funds use only 1–1.5x, meaning the risk on this exposure for banks is far lower than the typical risk on their balance sheets.
• Credit Risk Transfer (SRT): Banks sell the senior loss tranches of portfolios such as credit card loans and mobile home loans to private credit institutions to obtain regulatory capital relief. Such transactions are already common in Europe and are growing rapidly in the US. Typical examples include joint venture platforms set up by AGL/Barclays, Wells Fargo/Centerbridge, and Beach Point/KeyBank.
• Joint Venture Platforms: The bank originates assets, the private credit provider furnishes the majority of the capital, with the bank typically holding a 12.5% equity stake and serving as the senior lender in the off-balance-sheet vehicle. This allows the bank to retain client relationships while transferring credit risk to specialized private credit institutions.

Extrapolation and Validation: This cooperative model is expected to continue expanding, particularly in the US SRT market. Validation signals: whether the Federal Reserve continues to approve such transactions as a means of regulatory capital relief; and whether banks continue to sell non-core business asset portfolios to private credit.

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BDC's Structural Evolution and Leverage Safety Margin

Josh Clarkson argues that the statutory leverage cap on BDCs (initially 1x, later relaxed to 2x), combined with their historically extremely low loss rates (only low single digits), together form the core argument for their manageable systemic risk. At the same time, the distinction between BDCs as a "wrapper" and strategies such as direct lending is critical.

• Historical Evolution: BDCs were created in 1980 to address the decline in bank lending to small businesses. Early on, they were internally managed and faced development constraints. The financial crisis served as a "light-switch" moment, transforming BDCs from vehicles primarily serving mid-cap companies into tools for large transactions that directly compete with syndicated loans and high-yield bonds. The first $1 billion unitranche loan appeared in 2016; today, unitranche loans of $2–3 billion are common, and a few have exceeded $5 billion (including delayed-draw loans and revolving credit facilities).
• Leverage Mechanism and Safety Margin: BDC leverage typically ranges from 0.75x to 1.5x, and the bank senior loans have substantial subordinated layers (including CLOs and unsecured financing). During COVID, some BDCs triggered "margin calls" on their bank lines as asset values fell, but they resolved the issue by issuing equity (i.e., dilutive capital raises), and banks were never impaired. This historical case demonstrates that even under stress, BDC equity capital can absorb losses without forced asset sales that would create systemic risk.
• Distinction Between Strategy and Wrapper: Direct lending (approximately $1.5–1.7 trillion, more than half of the roughly $3 trillion in private credit) is the largest strategy, typically lending to private equity-backed companies based on EBITDA or ARR. Other strategies include asset-based finance (ABF), venture debt, life sciences, etc. Wrappers include: private institutional drawdown funds (similar to PE funds), publicly traded BDCs, non-traded BDCs (no capital calls, 1099 tax reporting, quarterly liquidity), and BDC ETFs (e.g., passively managed BizD and actively managed Putnam products). Non-traded BDCs are the fastest-growing segment.

Extrapolation and Verification: The ability of BDCs to raise equity is the key buffer. In the event of a more severe credit event in the future (e.g., a default wave on the scale of 2008), the question is whether BDCs can continue to access equity financing (even if dilutive) to maintain compliance with bank lines, rather than being forced to sell assets. Signals to watch: the discount of publicly traded BDC share prices to NAV; redemption pressure on non-traded BDCs.

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Rising Interest Rates: Net Positive for BDCs, but Dampens Transaction Activity

Josh Clarkson argues that the rate hikes since 2021 are a net positive for BDCs overall (floating-rate assets deliver higher nominal returns), but they also create challenges for portfolio management and new deployment by raising the interest burden on existing portfolio companies and reducing M&A activity.

• Positive Effect: BDC assets are all floating-rate, and a rise in the benchmark rate (SOFR) directly pushes up nominal returns. Since 2021, public BDCs have outperformed the S&P 500 index.
• Negative Effect: Existing borrowing companies face interest pressure, but the "bilateral direct relationship" of private credit allows for negotiated adjustments (e.g., interest rate resets, requiring sponsors to inject additional equity, tightening covenant terms such as minimum MOIC thresholds). Rising rates also suppress M&A activity, resulting in fewer deployment opportunities than the "golden age" had anticipated. However, this also means no one has lowered standards just to lend—a healthy signal.
• Opportunity Layer: Higher rates have created "rescue lending" opportunities—not requiring bankruptcy restructuring, but providing mezzanine or second-lien financing to help companies transition until rates decline or earnings improve. This requires specialized expertise that not all institutions can handle.

Deduction and Verification: If rates remain elevated for a prolonged period, will the default rate on the existing loan portfolio rise? Attention should be paid to the BDC's non-accrual loan ratio and the ability of net investment income to cover dividends. In the near term, expectations of lower rates may bring refinancing opportunities, but sponsors typically include provisions such as "minimum MOIC" in loan contracts to prevent premature refinancing.

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Future Outlook: Brand Differentiation and Capital Inflows Across Wealth Channels

Josh Clarkson predicts that private credit will continue to grow, particularly in the asset-backed financing space; at the same time, for institutions that are not top-tier in scale, establishing a clear brand and level of professionalism will become key to sustained fundraising.

• Growth Direction: Asset-backed finance (ABF) is expected to grow significantly; private credit will become increasingly important in alternative GP fundraising portfolios.
• Brand Differentiation: Since most direct lending strategies are structurally relatively homogeneous (SOFR + mid-single-digit spreads, sponsor support), different institutions need to establish a unique "label"—such as non-sponsor capabilities, stressed-period expertise, or the safest senior loans. This is especially important for fundraising targeting the wealth channel.
• Public BDC Outlook: The listing of three BDCs in early 2024 indicates that market confidence in public BDCs remains. Private BDCs can accumulate an asset track record and then go public, or merge into an existing flagship public BDC.

Extrapolation and Verification: Over the next 3–5 years, the size of private credit may continue to climb from $3 trillion, but growth will come more from "non-standard" strategies (e.g., life sciences, NAV financing, SRT) rather than traditional direct lending. Verification signals: fundraising scale of non-traded BDCs; changes in the share of new entrants (e.g., bank-affiliated players).

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Referenced Targets

This section is omitted, as the guest did not provide specific position moves or in-depth analysis of individual companies, only mentioning them as industry examples.

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Judgments Worth Remembering

1. Josh Clarkson believes that private credit and banks are more cooperative than competitive: banks, by providing leveraged loans, participating in SRTs and joint venture platforms, are actually key enablers of private credit growth rather than pure adversaries.

2. BDCs' leverage limits (0.75–1.5x) make their systemic risk much lower than that of traditional banks (10x leverage): during COVID, BDCs responded to bank line margin calls through equity financing, and banks were never impaired, proving that equity capital can absorb losses without needing asset sales.

3. Unitranche loan size has surged from $1 billion in 2016 to $2–3 billion today (some exceeding $5 billion), showing that private credit has grown from a "mid-cap alternative" to a mainstream financing tool directly competing with syndicated loans.

4. Rising rates are a net positive for BDCs but suppress deal activity: floating-rate assets deliver higher nominal returns (BDCs have outperformed the S&P since 2021), but fewer M&A deals lead to less capital deployment than expected; however, this also avoids lowering standards to lend.

5. Non-sponsored lending is a growth opportunity but difficult to scale: non-sponsored loans offer better spreads, lower leverage, and better terms, but require actively seeking out fragmented family-owned businesses, whereas sponsor relationships provide a steady deal flow.

6. Brand differentiation will be critical going forward: for private credit firms that are not top-tier in scale, they must establish a clear "label" (e.g., non-sponsored capability, distress expertise, or the safest senior loans) to stand out from the homogenized direct lending market.

7. Public BDCs have not been replaced by private BDCs: the three BDC IPOs in early 2024 show that private BDCs can go public after building a track record, or merge with an existing flagship BDC; the market still recognizes the liquidity value of public BDCs.