Why Do Borrowers Use Private Credit?

Why Do Borrowers Use Private Credit?

One of the common questions we hear from investors is, 'if private credit loans are so expensive, why do borrowers accept them?' This article highlights the regulatory shift that has acted as a tailwind for the wider adoption of private credit loans amongst commercial borrowers.

3 min read

One of the main attractions of private credit from an investment standpoint is the higher-than-average yields the sector provides (compared to the interest rates on investment-grade bonds, and stock dividends). Of course, for investors to earn those yields, someone has to be willing to pay a higher-than-average interest in the first place. 

This begs the question: Why would any borrower take out a private credit loan? 

Many investors assume that borrowers who take out private credit loans must be super risky, because–as the theory goes–if they didn’t carry so much risk, they’d be able to get a less costly bank loan. While private credit loans are a more expensive option, it doesn’t necessarily follow that borrowers who obtain such loans are any riskier from a credit perspective. 

As the below graph illustrates, small and mid-size enterprises (SMEs)–often the recipients of private credit loans–have similar default rates as larger enterprises, which typically obtain loans from banks. This implies that lending to SMEs (the typical private credit borrower) is no riskier than lending to large corporations from a capital preservation standpoint.

Source: OECD - N.D.

Of course, the above data gives way to another question: If SMEs are no riskier than large enterprises, why aren’t banks lending money to them? 

You Must be This Tall to Ride

There are various reasons why banks have been eschewing SME lending: 

  • Stricter Regulations: After the 2008 financial crisis, congressional regulations like Basel III imposed higher capital and liquidity requirements on banks. This has forced banks to scale back their lending, which means creditworthy businesses are unable to secure a bank loan. This is especially true for small and medium-sized businesses. 
  • Limited Profitability and Lack of Collateral:  Many high-growth businesses may have limited profitability and a lack of collateral in their early stages, making them less attractive options for traditional banks focused on established cash flows and collateral requirements. Private lenders are more willing to fund growth potential than banks, which makes them a better fit for growing businesses. 
  • Customized Financing: Growing businesses also may require tailored financing solutions that traditional banks cannot provide. Credit agreements with banks tend to be more standardized vs. the flexible and customized offerings provided by private lenders.  

For these reasons, banks have been shifting away from the SME market and towards the larger end of the lending spectrum. 

As banks have been making fewer and fewer SME loans, a gap in the market has appeared. Businesses need capital to grow–if banks aren’t there to fill that need, then who will step up to the plate?

On Deck: Private Lenders

Private credit funds have been more than happy to pick up the slack left by banks. Excess demand has led to record growth for the industry, from both a fundraising and AUM perspective. 

Source: data from Preqin - N.D.

Source: data from Preqin - N.D.

And many believe the future is even brighter for the sector. Insurance companies and investment banks are deepening their ties with private credit funds, prominent institutions like Goldman Sachs are raising huge sums for private credit investments, and even individual investors are getting in on the act

The key takeaway here is that private credit loans are being made to creditworthy lenders that banks simply cannot lend to for regulatory reasons. 

In other words, banks have (to a certain extent) been regulated out of the SME market, which has left many SME borrowers in a lurch as they look to secure debt financing. 

It is up to the private credit funds themselves to perform the necessary due diligence on these borrowers to determine which are the most creditworthy. Which is why investors looking at diversifying into private credit should consider doing so via a platform that enables access to curated investments across a range of private credit funds. 

Let those experienced fund managers diligence the underlying borrowers, and access their deal flow at a fraction of the typical minimum investment amount required by most private credit funds.