The Ascent of Asset-Based Lending Strategies

The private credit asset class has benefited from explosive global growth with AUM estimated at $2.1 trillion. In the US, private credit has grown at an annual rate of 20% over the last five years (see Exhibit 2). Non-bank lenders have taken the lead in providing capital to creditworthy borrowers who cannot access financing, and technology has increased the efficiency of transactions for businesses and consumers.

Private credit covers a wide array of underlying strategies with a diverse set of return drivers. The universe of private credit can be segmented into four sectors: Corporate Credit; Specialty Finance; Structured Credit; Real Assets Credit. Specialty finance strategies are income-oriented and comprise asset-backed trade finance, receivables, consumer lending, royalties, insurance-linked, etc.

The growth in private credit has been driven by the continued trend of bank disintermediation and strong, risk-adjusted return performance relative to other major asset classes. Bank disintermediation has occurred due to increased bank regulations and capital requirements following the global financial crisis, which has caused a reduction in banks’ balance sheet capacity to hold risk-weighted assets. We have seen a recent trend of large banks start to team up with large private credit firms (e.g. Citigroup, Apollo) to provide banks with an opportunity to maintain their fee streams without using their balance sheets.

Source: https://www.imf.org/en/Publications/GFSR/Issues/2024/04/16/global-financial-stability-report-april-2024?cid=bl-com-SM2024-GFSREA2024001, accessed as of Nov 11, 2024

Source: https://www.federalreserve.gov/econres/notes/feds-notes/private-credit-characteristics-and-risks-20240223.html, accessed as of Nov 11, 2024

Note: This chart plots aggregate assets under management (split by called capital or invested capital, and dry powder) sorted by private credit firm. For each firm, all fund level private credit funds are aggregated.

Source: https://www.imf.org/en/Publications/GFSR/Issues/2024/04/16/global-financial-stability-report-april-2024, accessed as of Nov 11, 2024

Most of Private Credit is Part of the Private Equity Ecosystem

The majority of the private credit universe is highly interconnected to the private equity ecosystem as a large portion of private credit loan funds are managed by private equity firms and private credit funds have high lending exposure to portfolio companies owned by private equity funds, with private equity sponsored borrowers representing 70% of private credit AUM. This creates the potential for meaningful conflicts of interest.

Private Equity Has Moved into a Challenging Environment

Direct lending private credit strategies are exposed to the common risk factor of corporate credit risk. The credit risk is concentrated in technology and health services and borrowers are typically smaller, leveraged companies financed with floating-rate debt. Private equity has been faced with a myriad of challenges over the past few years since base rates were hiked in 2022:

• Reduction in exit opportunities
• Levels of dry powder at all-time highs of $2.6 trillion (see Exhibit 5)
• Increasing competition for deals
• Longer portfolio company holding periods
• Secondary market valuation pressures via increased supply of LP interests in the secondary market
• Shift to negative net capital distributions has led to higher than target LP allocations
• Rise of continuation funds to rollover undistributed portfolio companies
• Increase in GP leverage via NAV financing

Source: https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/private-equity-dry-powder-growth-accelerated-in-h1-2024-82385822, as of Nov 11, 2024

Source: https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/private-equity-buyout-funds-show-longest-holding-periods-in-2-decades-79033309, accessed as of Nov 11, 2024

Direct Loan Stress is Beginning to Emerge

At the same time, the traditional private credit direct lending sector is also showing signs of becoming more crowded and riskier as private equity has experienced increasing signs of stress since base rates were hiked in 2022. However, the increased stress has not translated yet to default rates as they are in line with historical averages. Private credit direct loans are unregulated and typically have stale valuations given there is no secondary market – market-to-model is used to estimate market prices which may not be fully reliable.

• Highly-leveraged companies backed by private equity have experienced increased funding costs given the floating rate nature of their loans which has resulted in a significant decline in interest coverage ratios

Source: The interest coverage ratio (defined as adjusted EBITDA divided by total interest expense) can be used as an indicator of credit stress. Average interest coverage peaked at 3.5x in Q4 2021 near the end of the extended low-rate cycle, fell to 1.7x by Q1 2023, https://hl.com/insights/private-performing-credit-index-study-5-interest-coverage/

• Private credit funds have started to provide loans to larger corporate borrowers to expand their opportunity set which has led to a lowering of underwriting standards and covenants (International Monetary Fund - Global Financial Stability Report, April 2024)
• The higher base rate environment has increased companies cost of borrowing, created cash flow pressures, reduced earnings multiples negatively impacting the underlying health of highly levered companies (International Monetary Fund - Global Financial Stability Report, April 2024)
• There has been an increase in refinancing practices to try to mitigate some of the stress on portfolio companies via both payment-in-kind (PIK) and synthetic PIK utilisation:

o PIK allows borrowers to pay a higher interest rate to defer interest payments and add the PIK to the loan principal at maturity to provide companies with short-term breathing room to maintain their liquidity

o PIK increases the overall debt burden on the company which effectively just kicks the can down the road. It also results in higher leverage ratios which increases the stress risk of a wave of defaults in the private credit ecosystem

o There has also been an increase in the use of synthetic PIK which is a delayed draw term loan (synthetic interest payment facility (SIPF) which allows the borrower to draw down funds to pay cash interest on the primary loan instead of making traditional PIK non-cash in-kind payment

The synthetic PIK preserves interest coverage ratios, avoids PIK caps and is not reported as a PIK. The use of synthetic PIK’s allow for the masking of underlying credit problems and is a sign of increased credit stress

Source: https://www.fitchratings.com/research/corporate-finance/rising-payment-in-kind-trends-in-private-credit-will-have-mixed-impact-27-03-2024, accessed as of Nov 11, 2024

Asset-Based Lending as an Attractive Complement to Direct Loans

Private credit, asset-based lending (ABL) receivables and consumer strategies, such as Fasanara’s, are an attractive complement to direct lending private credit strategies as they have a very different profile relative to direct loans:

• ABL allows investors to add diversification relative to private equity sponsored corporate credit exposure which represents the lion share of private credit universe allocated by institutional investors. ABL strategies take a different approach by constructing more diversified portfolios, which, we believe, result in more stable returns with a lower risk profile
• ABL is a natural complement to private credit direct loans given the differences in the underlying credit exposures and framework – ABL has more diversified underlying assets, shorter duration, self-liquidating, no exposure to the private equity ecosystem, non-correlated to public or private markets, easier to value, transparent, with strong documentation and credit enhancements which improve downside protection
• ABL strategies, such as Fasanara’s, require highly specialised expertise and technology and, as a result, have high barriers to entry. It is operationally demanding to properly source, analyse and originate ABL strategies and success requires credit underwriting expertise, data analytics, deep industry networks and a long track record of experience
• The ABL playing field is less crowded as there is limited institutional competition for transactions within the ABL receivables and consumer loan space, given that large multi-strategy private credit managers have not made the large investment in data analytics and technology needed to participate in this space in scale

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