Build Robust Client Portfolios by Integrating Private Credit

Build Robust Client Portfolios by Integrating Private Credit

Richard Kuhn
Hello. Welcome to today’s webcast. Building robust client portfolios by integrating private credit. My name is Richard Kuhn, head of product here with Thornburg. Before we jump in a couple of housekeeping items. Today’s session is being recorded and an email will be sent next week. Second, we do welcome questions, but all participants are in listen only mode, so if you do have questions, please submit them through WebEx or email questions at Thornburg.com. It’s my pleasure to introduce two of my colleagues to my immediate last left, Josh Apfel, director with Thornburg Bow River Private Credit team. Next to him is Danny, vice president with the Private Credit team. So, gentlemen, thank you for joining us. Let’s jump in. Josh, can you give us a brief history of private credit?

Josh Apfel
Absolutely Rich, thanks. So private credit been around some form or fashion for over 30 years, but it’s really experienced significant growth over the last 15 years since it almost $2 trillion is an asset class today and a variety of different strategies and risk return profiles. So, let’s kind of walk us to where we are today. Right? So before 2008, 2009, the space was primarily dominated by mezzanine and distressed strategies.

Then, the GFC happened and everything changed in the years following the GFC. New regulations really pushed banks to scale back traditional lending to corporates and that really transformed the lending landscape. Asset managers recognized this need for capital. They also saw the opportunity shift. So, as corporate lending for banks declined, the leveraged loan markets emerged to really fill the gap for larger borrowers and at the same time, direct lending did so with respect to middle market businesses. It really emerged as a true standalone asset class post GFC. And as this new era of private credit ramped fund managers developed and continued to develop creative strategies to provide capital to companies, meeting solutions beyond what traditional bank lenders could offer.

Fast forward, you’re in 2015 to 2021. This is when investor interest really started to pick up. You had a low interest rate environment that motivated investors to really seek out yield beyond traditional fixed income. Private credit gave them that illiquidity premium. So, you know, we’re able to kind of get that premium over the public markets.

Then 2020, the traction really intensified for two key reasons. One, you had accredited investor rules relaxed for BDCs. That led to a large growth in AUM from the wealth channel. So a new form of investor base kind of coming to market. At the same time you had COVID and that dislocation led to the rapid growth in distressed investing AUM.

More recently, you know, private credit has really gain market share at the bottom and top into the markets on the lower end. We’ve all seen significant issues with respect to regional banks. That pullback has allowed private credit to really step in and provide solutions to more lower middle market and middle market businesses taking more of that market share away.

At the same time, we also saw a dislocation in the liquid credit and broadly syndicated loan markets. So that allowed larger private credit managers to start getting additional market share at the top end of the market.

So a common theme here is really this bank pullback, right? Bank retrenchment, that’s a common theme over the last 15 years and private credit emerging to fill the gap. So just to kind of level set, right? Banks really moved away from direct lending to large cap companies in the early 2000, but they still dominated the middle market. However, as time went by, particularly from 2014 to 2023, that declined as well. In fact, the share of lending from banks to private equity bank middle market companies dropped from 60% to only 15%. That obviously coincided with the rise of direct lending as a stand alone asset class.

But bigger picture, as increased regulations made it less economical for banks to generate true revenue from lending, they had to prioritize and pivot to more fee-based income streams with lower charges. So on this chart, you can see, you know, overall banks aggregate lending as a percentage of GDP declined over 10% since the GFC. And again, that gap was filled on the public market side by leveraged loans. And then to the point today, with respect to private credit, non-bank lenders.

Richard Kuhn
Thank you, Josh. Danny, can you put where are we today and can you put the asset class in context relative to the global markets?

Daniel Parks
Certainly, yes. So, you know, the estimates of the size of the private credit market today range from anywhere from 1.3 trillion, all the way to in excess of 5 trillion wide range. But it’s really driven by a lot of the specialty finance kind of sub asset classes of private credit that have developed more recently where the market data is a bit more opaque.

But you know, where we’re going to focus today is really on the traditional definition of corporate private credit, which is you think about a directly originated plan between a non-bank lender and a business, corporate business. And there’s much more consensus around the size of that market. It’s been established for much longer. And so estimates there are about 1.7 trillion of private credit AUM globally.

And if you kind of break that down into the subsectors within corporate private credit, you have first the largest share over 50% of the market is, you know, senior direct lending. So you think of that as first lien loans at the top of the capital structure, really kind of a replacement for bank financing that Josh alluded to earlier. And that’s where it’s where we’ve seen most of the growth over the last few years, at least in the corporate credit credit space.

And then if you move down a bit, the next kind of I’d say third of the private credit, corporate private credit market kind of a mismatch of primarily mezzanine, but as well as some opportunistic and kind of blended strategies. So again, lending to performing companies, but potentially further down the capital structure or a mix of senior debt, junior debt and even some small equity co-invest positions that are that are common in the mezzanine space.

And then finally you have the distressed and special situations part of the market. So this has been, you know, a staple of the private credit market for 20-plus years. It’s about a third of the market today. And that’s they’re obviously focusing on underperforming or non-performing companies. So kind of totally different target borrower. And you typically see a mix of debt and equity held in those types of strategies.

And so you take a step back that 1.7 trillion of corporate private credit. How does that kind of look in terms of the global market portfolio? It’s about 1% of the public fixed income market. So still a tiny fraction. You compare it to its private asset class counterparts relative to total private capital, about 13%. A little bit more relevant, but relative to private equity, you know, so it’s kind of long-term partner in this growth we’ve seen over the last 20 years. It’s about still only about 18% of that. So, you know, not as big as one maybe may think.

Richard Kuhn
Thank you, Danny. So you both have talked about the growth of private credit and its role from a borrower’s perspective. Let’s flip it around. What about from an investors viewpoint?

Josh Apfel
Sure, Rich. Yeah. You know, there’s private credit possesses several characteristics that make it very appealing. A very compelling opponent, excuse me, component of an investment portfolio.

So first, looking to, you know, how private credit sits relative to its public counterparts. So private credit, or more specifically, direct lending, as Danny alluded to or commonly shown here on this chart, is the Cliff Water Direct Lending index that’s commonly utilized to reference the performance of direct lending. That’s outperform liquid credit, so leveraged loans, high yield investment grade over the last 20 years, that’s two cycles of rising rates recessions and recovery. So unlike public markets, which are subject to frequent price swings, they could sometimes be more driven by sentiment and flows rather than actual fundamentals. Private credit investments tend to experience less volatility.

You know, just thinking about both asset classes, right? Credit quality is a key factor in both markets, both public and private. But private credit generally affords investors a premium in spreads of 200 to 600 basis points versus public debt. So, you know, just thinking about the underlying instruments themselves to write, direct loans tend to have carrying should be tend to carry a floating interest rates that reduces interest rate risks and provides protection against rising rates.

Again, relative to public fixed income, there are typically stronger protection, actually stronger structural protections versus public fixed income. You know, think the financial maintenance covenants, they provide early warning signs to borrowers and lenders so that people can come to the table and intervene proactively, collaborate, to ensure that you’re preserving value.

And moving aside from private credit relative to its public debt counterparts, even within the alt space, it affords some great premiums and some great optionality to help diversified portfolio. So it’s a risk diversify in that regard.

You know, private credit has defined duration, contractual yield, it’s often secured by collateral, has a senior position in the stack, and it contributes because of that strong downside protections and a shorter investment horizon versus, for example, private equity and venture capital.

And because private credit is yield oriented, right, a lot of these strategies, most distribute income on a quarterly basis. You know, and there’s also less valuation sensitivity. This asset class has actually performed well versus other private asset classes in recent years as distributions, for example, from private equity vintages, recent ones, has significantly lagged historical rates.

Richard Kuhn
Yes. So let’s touch on that a little bit more. What about access? How are investors accessing it and what are some of the key characteristics of some of the existing strategies?

Josh Apfel
Right. So as I mentioned, you know, Danny has mentioned too, private credit, it’s really grown and evolved to encompass a wide range of options and strategies, which allows an investor to construct a diversified portfolio of complementary approaches. Not too dissimilar from any other asset class, public equities, you know, private equity, you name it.
There’s a variety here that you can tap into.

But just even focusing on corporate private credit or direct lending, there’s different flavors here or mostly commonly is seen as senior secured loans. It also includes more opportunistic like capital solutions strategies like mezzanine, junior debt. As Danny talked about earlier, as well as distressed special situations.

And so even though I mentioned earlier, private credit is seen as a yield-oriented product, you know, as you move away from traditional senior lending, capital appreciation can really become a meaningful contributor to total return.

So the reason why I’m calling out and while we’re calling out different strategies, is that there are different underlying risks and return profiles to be mindful of. Right? So, you know, even in corporate private credit, not all strategies are the same. They’re created in many different flavors. But by leveraging this variety, investors can tailor their exposure across risk and return profiles, while also benefiting from private credit structural advantages that I spoke about earlier. So that’s just a variety of things that you can touch upon.

Now, thinking about structure, right? There’s a variety of different ways in which investors can access private credit. On the one hand, as you see on this chart here, there’s BDCs, whether it’s public, BDCs. Non-registered BDCs and interval funds share many of the same characteristics. They tend to be very large, having either hundreds to thousands of investments, pieces of different loans tend to be upper middle market to large cap company exposure.

There’s different, you know, elements to liquidity, right? So when you invest in these structures, your money is invested. On day one, you get exposure to these different investments and then you can have monthly or quarterly redemptions, right, in terms of 5 to 10% over time.

So on the flip side, when you think about the more traditional closed ended private funds or even hybrid funds, they tend to lean towards strategies that are alpha-oriented.
They target higher returns. So there’s typically more capacity constraints. They’re less scalable on a relative basis. So that’s why with this illiquid asset class within their portfolio, they tend to be funds in less liquid fund structures.

But something to note the big differentiation between hybrid funds and traditional closed ended private credit funds is with hybrid funds similar to BDCs, you can obtain your target level of exposure. Let’s say, I want 5% of private credit in my allocation in my portfolio.
You can achieve that, albeit over a bit longer. As I mentioned, interval funds and BDCs, your money gets invested on day one. There’s a ramp up period because this is a drawdown vehicle. So you can maintain that exposure though, with hybrid funds throughout your life of investing in this vehicle and you can reduce it at your leisure.

That’s different with respect to traditional closed ended funds, as you have to manage that exposure over time as you ramp up and wind down each vintage of vintage one, vintage, two vintage three of these funds. So you don’t have the ability to really maintain that consistent exposure over the course of your investment period.

Richard Kuhn
That’s a great foundation and background. Gentlemen, I really appreciate it. I want to pivot a little bit and dive a little deeper into recent trends. You both have talked about the growth.
You’ve talked about the acceleration of that growth. You’ve mentioned that the AUM for private credit is similar to leverage loans. The obvious question has grown too quickly, too fast. Is the golden age of private credit over?

Daniel Parks
Yeah, I can take that one. I mean, I think the it’s helpful to look at the size of the private credit market and the growth relative to the opportunity set and the demand for the product. And so that’s right. Now, I think it’s the best way to determine is recent growth sustainable?

And there’s there’s a couple of potential indicators that we’ll hit on here that could either show signs of excess or signs of, you know, nothing really to to worry about. You know, the first of we’ll talk about is on the demand side – is all of this private credit that’s being raised then, is it being deployed? So are managers finding places to put it?

The second – is leverage increasing in the system? So, you know, are earnings growing or are borrowers just taking on more debt because there’s a flush of capital available to them?

And the last is is around more around the opportunity set in terms of market share. And so on the demand side here, you can see on this chart where we’re showing private credit, dry powder. So, this is capital that’s been raised by managers but hasn’t yet been invested. So it’s sitting on the sidelines. At about $210-$220 billion in North America, it’s doubled over the last couple of years. First glance that seems concerning. What’s not on this chart is the deployed portion of private credit AUM and that’s actually growing faster. So the ratio of capital to private credit capital on the sidelines relative to invested has actually declined.

So more capital is being raised, yes, but it’s actually being invested faster. So I think that’s a supportive signal, at the very least. And specific to this chart with the green line we’re showing kind of more of a supply debt supply demand dynamics. So, if you think of private credit, dry powder is supply, private equity, dry powder is demand as that gets deployed, it’s typically associated with debt. You know, the the ratio of the two has been relatively stable under 30% over the last few years. And if you you think about there’s there’s actually even potentially a large gap, and growing gap. Typical private equity buyout might be if funded with 50% equity 50% debt – which would mean there should be a 1:1 ratio of the dry powder of each.

You know, a 1:1 ratio applied to this chart would indicate another trillion dollars of demand for private credit, dry powder. And so, you know, that’s kind of the first indicator. Second, you know, are our borrowers getting more levered? And so this good chart that that shows kind of aggregate non-bank leveraged borrowing, that’s some word scramble there. But it’s a combination of private credit AUM, US high-yield bond and US leveraged loan AUM.

And then we’re showing that relative to kind of total non-financial sector profits. So what’s the debt in the system? What’s the earnings in the system? On a given borrower, you’d call that leverage debt to EBITDA. And the economy, it’s probably called something different. But you index the two starting back in 2010 and they’ve really grown in lockstep. So there isn’t really a kind of mismatch in terms of earnings and aggregate levels of debt.

And so the the next potential indicator I touched on is the opportunity set for private credit. And so here, you know, market share is really the story. And so, you know, Josh talked about it. I think it’s been a well-known long term secular trend, the pull back banks from traditional lending in the lower end of direct lending in the lower middle market, kind of well established trend there.

More recently and maybe more interestingly, there’s been a development where, you know, there used to be called, seven years ago, a hard line in the sand in terms of the size of issuers that would access each of these markets. So you think of an issuer with 50 to $100 million of EBITDA you had seven or eight years ago that would go to the syndicated loan market.

What we’ve seen over the last few years and we’ll touch on more later, is there’s kind of been a blurring of the definition of direct lending. And the result of that has been kind of this trading of market share between direct lending and the syndicated loan market. And so you can see that, prior to 2019, syndicated loan growth actually outpaced private credit growth and then 2019, they flipped. You know, pretty materially. So private credit’s grown 18% better, 18% over the last four years. Well, you know, it’s publicly traded counterparts, kind of still growing, but much lower rate. And you could see that in the the the dots on the chart there. That’s private credit as a percent of all three of those sum together. Pretty steady at around 15% until really the last few years when it’s jumped more than ten percentage points to 27%.

And so that’s, I think, an indirect way to get at that the market share market share and the opportunity set is expanding for private credit. And if you were to tie this back to the prior chart chart of, you know, total debt in the system versus earnings, that that trend line of aggregate leverage borrowing, it was 6% prior to 2019 when private credit was growing at a rate that didn’t get any attention.

Now that it’s growing 20%, the trend line for all three of those together still 6%. So it’s not pushing the aggregate leverage in the system up. You know, just another kind of data point that I think kind of shows that this recent growth is really, really more of a market share story than some supply demand mismatch.

Richard Kuhn
Yes. So those are really great points. But I want to focus on one of those items. You brought up the market share trends at the upper end of the PC market, which what’s driving that? And most importantly, I think for our audience, what are the implications for investors?

Josh Apfel
Yeah, I’m happy to jump in here, Rich. So the first point here is around what’s driving this change in the market share rate. And the key takeaway here is fundraising is increasingly concentrated in large managers, the big private credit shop.

So in 2024, for example, $5 billion plus funds raised more than half of all new commitments in private debt. That’s dramatic. And you know, in that year the top ten managers all with a in excess of $20 billion. Again they raised more than 50% of all new commitments in 2023, excuse me, that’s up from 35% in 2022. So that’s a dramatic increase in concentration in a very short amount of time.

Another key stat here, the top 50 private credit managers raise over 90% of capital in 2023. So what’s that causing, right? As a result of all this rapid growth and these emergence of these mega jumbo, private credit managers is that most, if not all of these managers, are doing what’s most the most economical form of from a business perspective. Right?

So what does that mean? They’re issuing larger and originating larger loans for larger companies rather than building up massive teams to originate more smaller loans to basically deploy these billions of dollars? Right? So just a quick anecdote here. The volume of directly originated loans in excess of $1 billion and the jumbo loans, right? That went from zero seven years ago to $80 billion in 2024. So the really moving up markets and jumping into arena that was previously fully serviced by the products syndicated loan markets.

Daniel Parks
Yeah. And I can touch on the implications of that, that market share shift. You know, two fold. I think the first is relatively obvious. It’s that, you know, direct lending is is no longer synonymous with middle middle market lending like it had been from 2000 to 2019.

The second, and more important for investors, is that upper middle market direct lenders, large direct lenders, are now not only competing with each other, but they’re competing with the entirety of the syndicated loan market. And I think most headlines I read around increasing competition in private credit, or the end of the golden era, kind of actually hit are mostly hitting on this point. And it’s valid. I mean, it’s a noteworthy shift in the market here.

And I think the chart on the left here just kind of illustrates that a bit. Over the last two years, you’ve seen $50 billion of the syndicated loan market getting taken out by direct lenders through refinancings. That’s about three and a half percent of the market just in two years. And that that doesn’t even cover the whole encompass everything that’s going on in the market because there’s still a number of new issues for larger issuers that, you know, seven years ago maybe under the syndicated loan market, but are now going to direct lending market.

So left chart doesn’t even paint the full picture of the impact, the right the right chart is kind of a way to indirectly get at that shift. So here we’re comparing the average, weighted average portfolio EBITDA of the top three BDCs taking the median of those three that collectively manage about 120 billion of assets. So, a very sizable chunk of the direct lending market, we’re comparing that versus the median EBITDA of issuers in the syndicated loan market. And you see the issuers the size of issuers in the syndicated loan market, you know, has 2Xed over the last five years.

And on the other side, you’ve seen the the size of companies in these top three BDCs, 2024, it was around 270 million of EBIDTA. So far in excess of what most people would add has historically been defined as the big core middle market and really creeping into that large cap space. And the size of those issuers, if you just draw a line across the chart, I mean it’s larger than the syndicated loan market issue it was even just three years ago.

So really rapid change here. And so I think it’s it’s natural to assume that there’s potential that as these the larger part of this direct lending market is competing with syndicated loans, there could be a convergence in terms of, you know, how loans are structured, how they’re issued, pricing, terms, documentation. And so, you know, and that’s a considerable size of, a considerable share of the direct lending market that’s now kind of facing those forces.

And so for investors, again, I mean, I won’t sit here and proclaim that I’m certain that the markets will become identical over some time period. But I think it’s worth consideration knowing that, you know, that there is a large part of this market that’s facing these these competitive forces.

Richard Kuhn
Yeah, that’s helpful. So, one, to make sure I understand a couple of things. The addressable market’s expanding. We have new competitors coming online. Where are the opportunities then?

Daniel Parks
Yeah, well, not when the new competition is coming from. So, you know, the this trend of competition at the upper end of the market moving out of the middle market – kind of – we talked about it for a fair amount of this this webcast but I think it’s important to highlight what’s going on there because it draws a distinction to being left behind, which is the core middle market and lower middle market, where 96% of the companies in the US sit.
So very sizable opportunity set.

And then you combine that with the continued secular trend in terms of banks pulling back. And you kind of think about the two forces moving out, moving away from the private credit market. And so, it’s maybe not the most original idea, but, you know, we think it’s it’s a compelling opportunity that’s being renewed by some of these recent developments in the market.

And, therefore, if we kind of level set, we’ve talked a lot about different segments of the direct lending market. So I think it’s helpful to just kind of put up a chart that lays out the different features of these different segments. And so if you can follow from the left to the right, you can see that core middle market and lower middle market. That’s companies with 50 million of earnings and below. As you move to the right, this third column. This is really what’s being redefined with direct lending over the last five years. Seven years ago, I don’t think it would have been worthwhile to put this column on the chart because it didn’t exist, this indicator loan market, which would take up both of those.

And so when you think about different features of the connected, the core middle market that we think make it pretty attractive, you’re picking up a a spread premium here. So, you know, the think about the kind of headlines you’ve seen maybe or people talking about is bigger better? Naturally, you would expect that to come out considering how much AUM there is there.

But it ignores kind of a couple of key aspects of the lower middle market, which are what are you getting paid to live there and what are the tools you have to manage and mitigate risk what you’re getting paid. You know, we see spread premiums in the lower middle market. Anywhere you get 400 basis points maybe and in terms of kind of downside risk mitigating.

So what are the typical ways you manage risk? And credit structures have covenants. How much influence do you have over the structuring the deal, but also control that you can have in a work out process? And that’s kind of inversely correlated to how many lenders there are in a deal. And so less lenders And typically seeing deals in the lower middle market means more control and more influence.

And the other aspect that’s tricky is just leverage. So what how much debt are you putting on businesses relative to their earnings at the onset at least? And you generally see 1 to 2 turns of a decrease in leverage as you move down.

And you can kind of see how those protections change as you move upmarket. And so, yeah, well, it’s it’s actually true that a larger company, all else equal, is less risky or more creditworthy. It kind of ignores the facts of the concept of what you’re getting compensated to lend there and how you can manage risk. And I think that the the the column or the row at the bottom there is the average recovery rate. That’s kind of the tale of the tape, right?

So larger company may be less risky, but structure can kind of mitigate that. And you may just be kind of moving risk from one place to another and got at least what we’ve seen through the data so far. You know, the middle market is is faring pretty well relative to these kind of larger companies. So that’s an interesting concept there. But, you know, the takeaway, I think, should be that the company size is is not the only factor that that you should use in determining the credit worthiness of a borrower and the attractiveness of our market segment.

Richard Kuhn
Understood. Where else can managers look for a premium? Where else are you looking?

Daniel Parks
Yeah. So this chart, I think we it’s it’s pretty illustrative of kind of different ways you can capture enhanced yield or return in private credit. It’s the forum we’ve touched on in great detail. the next one over, this non sponsored borrowers concept, So yeah, you can call it a non premium, you can call it or maybe even a complexity premium, but direct lending, you know, if you think about the growth of the asset class, it’s historically kind of tied at the hip with private equity. There’s actually a large portion of direct lenders that lend exclusively to private equity-backed businesses. That’s good. I mean, frankly, there are benefits, the real tangible benefits of targeting this market.

And private equity sponsors kind of actually do a lot of the legwork for for direct lenders in some of these situations. They they sift through a lot of non sponsored companies and vet them for quality. And and they find that these companies are harder to find. So they’re making more efficient to find good investable companies. But the tradeoff there is that if you’re only focusing on sponsor-backed businesses, you’re missing out on a very large portion of the US middle market.

Only about 14% of companies in the US middle market have it private, are owned by a private equity sponsor. So in that non sponsored universe, you have opportunity to really have proprietary sourcing and find kind of off market deals that are less competitive. And that’s generally going to lead to better pricing, better documentation, better terms and structure.

The tradeoff there, there’s always a tradeoff. You know, these companies, it requires a lot more manpower to to find those companies, sift through them. The underwriting structuring is more complex, takes longer. So it’s not it’s not a free lunch. It’s not a golden ticket. If it was, everyone would be focused there. But, you know, it’s it’s it’s interesting. And I think it’s indicative of it’s one is not necessarily better than the other all the time. It’s situation dependent and sponsors, I don’t want to discount the value that they do bring to the table. because it’s it’s meaningful. And oftentimes that can be worth giving up 1 to 2% in rate, but kind of just keeping that wider funnel and the ability kind of on a situation by situation basis or, you know, bigger picture of what’s going on in the macro environment.
Select between two and just fine find the best opportunities, you know, price risk in that way. It’s it’s definitely a less competed area of the market.

Richard Kuhn
Yeah. Great

Josh Apfel
So yeah, just to close out, Danny highlighted a number of premiums there. Size premium for middle market, upper middle market premium in that regard. Danny just spoke to the non sponsored premium investing and founder owned businesses and as on this chart here we also show the premium that you can achieve by investing in different parts of the capital structure. So the more mezzanine the junior tranches of debt is additional risk in that regard. But at the same time, you know, you’re paid a premium to invest those types of instruments.

But you know, these premiums and market segments can become more and less attractive in different macro environments. So or from one company to the next rates, if you evaluate it top down and bottom up. So we believe there’s an overarching opportunity for flexible private credit strategies and mandates that can pivot and target different premiums in different market environments and situations where risk is priced most appropriately.

Not only can this lead to better risk adjusted returns for investors and the fund, you know, is Arm’s a private credit manager with a broader toolkit of capital solutions that can also differentiate them versus their other competing capital providers. Whether it’s banks, whether it’s other private credit providers in any given deal process, which could ultimately reduce potentially the level of competition they face to achieve and even further premiums on that front so.

Richard Kuhn
Josh, Danny, thank you. We have a few minutes left and we are starting to get some questions from the folks online. Outlook for private credit in 2025. Can one of you address that question?

Daniel Parks
Yeah. No, I think I can touch on maybe deal activity and volumes as well as, the kind of just that and the underlying health of direct lending market and borrowers. In terms of activity,
you know, were we saw a chart the week it doesn’t look like P/E buyout activity is is back to its 2020 to 2021 peak. I don’t know that that will happen for for a while. We hearing about you know green shoots of activity. I don’t know how much of that is kind of just anchoring to the high water mark, but we are seeing valuations recover, or at least in the public equity markets.

If you take out the the NVIDIAs and things that skew it multiples more in the Russell 2000 type range, we’re seeing valuations going to pick back up, recover to around 2019 levels. And the thinking is obviously that that will unlock some of this kind of wide bid/ask spread that we’ve seen in the sponsor market that’s caused sponsors to to hold on to companies longer and not transact.

But I think that, you know, if that is done, like in my opinion, it’ll happen first on the smaller end of market where multiples tended to be lower to begin with. So they’re less rate sensitive. So I think there’s potentially signs of green shoots there.

Focusing specifically on, you know, credit. There’s a lot of there’s heard a lot of moaning about deal flow and activity being down, still being depressed. It actually in 2024 looked pretty similar to 22. It’s just coming from different, different sources. Right?
So obviously, LBO new insurance buyout that’s that’s down. But there’s still opportunity out there. Lots of other types of transactions and we alluded to earlier the sponsored versus non sponsored dynamic there’s still plenty of opportunity out there. And so I think 2025 will be either more of the same or still supportive.

In terms of just the underlying performance of borrowers. What to expect. I think 2024 was was relatively benign. I mean, loss rates wound up I think below historical averages. BDC non-accruals are at their lowest rate since 2019. You know, there might be, I could think of some challenged older vintages of private credit that were levered off of 0% interest rates. And again, the companies may be doing fine, but that’s still a massive spike in debt service coverage, or debt service costs, that’s going to drag down debt service coverage.

And you can kind of see that through the lens of BDC pick accruals, which have been ticking up. We’ve seen some relief recently. We’ll see where that goes with kind of the forward curve flattening out. But I’d say that’s more of a trend kind of just to watch, not something that that concerns me. So I overall I think that the outlook is pretty constructive for for 2025.

Richard Kuhn
Thank you. Thank you for that. Next question coming in. This one came in via email. Why would a borrower pay more for direct lending versus bank financing?

Josh Apfel
Yeah, I’ll take this one. Thanks, Rich. Yes, that’s a good question. Right. So something that spoke about quite a bit today is, again, bank retrenchment. So what’s been happening over the last 15 years and and it’s happened in spikes as well. And most in 2023, 2024 with the regional bank side of things. You know, banks are not providing the capital solutions that lower middle market middle market businesses need,right? So it’s just not available in a lot of instances.

You know, just that even if a company were to have an option, whether or not to choose a bank loan or a private credit provider, you know, there’s I’d say three key benefits and drawbacks to private credit.

So first, I’d say, you know, private credit provides customized and more flexible financing solutions. You know, as I mentioned earlier, private credit offers tailored funding structures that can be better aligned with the company’s specific growth needs. Less stringent on the same type of loan every single time. They can be a bit more flexible. And so that what that does is it creates alignment for long term financial stability for a business relative to a bank loan.

Second, private credit tends to be faster and simpler execution. Relative again, to a bank committee’s approval process. So there’s a lot more red tape. Not to say that there’s not a strong diligence process undertaken by private credit managers, and many of them utilize full on private equity style diligence. Right. But it still takes less time. There’s less formal steps that need to be taken to achieve the capital solutions these businesses need.

And then third and finally, you know, there’s certainty of execution in private credit, particularly during volatile markets. When banks who are, if they are more highly leveraged, can be required from a regulatory standpoint to tighten their lending standards. So, again, they’re pulling back in some instances, in some instances abruptly. And so the spigot can be shut relatively fast.

And so private credit is known to the lenders now as an established asset class, as a true provider that they can rely upon in good times and bad.

Richard Kuhn
Yeah, I think we have time for one more: Returns. So last question, how should investors compare returns?

Daniel Parks
Yeah, I can take that one and it’s probably a quicker answer, but I think the first is, you know, you need to make sure that you’re comparing two similar strategies. Josh talked about the direct lending, opportunistic capital solutions, mezzanine, distressed, and sometimes those all get bucket into one or private credit bucket. They shouldn’t be.
So if you use kind of yield and loss rates to compare to different senior direct lending funds, that that makes sense. If you’re using it to compare it to a distressed fund, it’s not going to make as much sense.

The second is it’s the biggest points probably around the fund leverage. And so there’s there’s private credit funds out there that are unlevered. There’s a lot that hang out, hang around one time, 1 to 1. That’s generally where you see a lot of BDCs, right? And then there are some private, private funds that target leverage one and a half times. They’re really not all the way to two, but they have flexibility to go to two. And so now you need to kind of think about the, what’s the return from the underlying strategy? What’s the risk with the underlying strategy? And what’s the return and risk at the fund level? And I think there’s there’s not a lot of great historical data about the tradeoff between risk and underlying strategy versus fund level.

So It’s kind of a wait and see. So that one’s a bit tough. But I think it’s, you know, investors should at least be mindful that there are differences out there.

Richard Kuhn
Yeah. Gentlemen, thank you. We are a time audience. Thank you. We hope you found this. The session today informative, relevant and timely. And if we didn’t get your questions, please feel free to reach out to your third Thornburg representative. Thank you.

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