Private Credit Outlook 2024: Navigating through credit opportunities

Executive summary:

• First, the retreat of traditional banks, exacerbated by recent regional banking crises in the U.S., has created ample opportunities in asset-based lending. Small and mid-size companies, unable to secure financing from conventional sources, are turning to alternative capital providers. 
• Second, in the upper middle market, heightened competition poses challenges, but also offers strategic opportunities. By partnering with top-tier general partners during periods of limited competition, investors can deploy capital effectively. 
• Third, European markets offer favorable conditions for senior secured lending, with wider spreads and tax advantages for non-U.S. investors. 

1. Banks stepping back further: Regional banking crisis creates opportunities

The recent regional banking crisis in the U.S., exemplified by the struggles of institutions like Silicon Valley Bank, has further intensified the ongoing trend of traditional U.S. banks withdrawing from extending loans to small and midsize companies. This is partly attributed to the sustained decline in the count of commercial banks operating in the U.S., as evidenced in Exhibit A below. This has opened significant opportunities in asset-based lending for private credit investors.

Exhibit A: Number of FDIC-insured commercial banks in the U.S.

Source: FDIC. Data accessed on 27th March 2024. For illustrative purposes.

Asset-based lending is a financing model where a loan is secured by collateral, typically in the form of the borrower's assets, such as accounts receivable, inventory, equipment, or real estate. Thus, quality small and midsize companies that cannot access financing from local banks are turning to alternative sources of capital, creating a robust supply of potential investments within the asset-based lending space. Unlike corporate lending, asset-based lending tends to be more recession-resistant, offering a cushion against economic downturns.

Exhibit B: Private asset-based finance growth forecast ($ trillion)
Source: Integer Advisors and KKR Credit. Data as at January 2024. For illustrative purposes.

Private credit investors can capitalize on this supply of opportunities and exercise selectivity to build resilient portfolios. Exhibit B underscores the trajectory of substantial growth anticipated in asset-based finance over the forthcoming years, portraying a landscape ripe with opportunities for expansion and innovation within the financial sector.

2. Upper middle market lending: Navigating competition and pricing power

In the realm of upper middle market lending, private credit faces heightened competition, especially with the return of collateralized loan obligations (CLOs) as leading competitors for deal. The influx of capital into the market can sometimes lead to temporary spikes in competition, making it crucial for investors to adapt strategically. Despite this, competition tends to be transient and varies depending on market conditions.

This dynamic creates tactical opportunities for investors to capitalize on periods of limited competition by partnering with best-in-class general partners (GPs). Many of these top GPs have a proven track record of success and a flexibility between direct origination up and down the size spectrum, while also pivoting to secondary market purchases in certain markets. By doing so, investors can deploy capital into the upper middle market when the landscape is favorable, while also diversifying their investments through core middle market direct origination in other markets.

However, navigating this competitive landscape requires careful consideration. Investors must maintain pricing power and secure favorable terms to ensure the viability and profitability of their investments. This entails thorough due diligence, strategic partnerships, and a keen understanding of market trends and dynamics. By leveraging these tactics, investors can optimize their investment strategies and capitalize on opportunities in the private credit market.

3. European opportunities: Favorable conditions for senior secured lending

In Europe, plain vanilla senior secured lending presents itself as an increasingly attractive option for private credit investors. Unlike the U.S. market, where spreads tend to be narrower due to a more mature financial landscape and higher liquidity levels, European spreads are wider (please see Exhibit C), offering the potential for higher returns and enhanced yield. This can be particularly advantageous for investors seeking diversification and potentially higher risk-adjusted returns in their portfolios. This disparity in spreads underscores the allure of European markets for investors seeking to capitalize on favorable lending conditions. Moreover, the recent withdrawal of a prominent European private credit manager from the market has created at least a temporary gap in funding for prospective borrowers.

Exhibit C: Spreads (basis points) on U.S. vs. European loans
Source: Pitchbook / LCD as at February 2024. For illustrative purposes.

Additionally, European direct lending offers a significant tax advantage for non-U.S. investors, as they are not subject to the same tax and structuring constraints as their U.S. counterparts. This tax advantage enhances the attractiveness of European senior secured lending as a viable option for diversifying private credit portfolios and tapping into opportunities across global markets.

From our vantage point, the combination of wider spreads resulting from market volatility, occasional temporary gaps in funding due to fluctuating economic conditions, and favorable tax conditions make European senior secured lending an exceedingly enticing proposition for private credit investors seeking to diversify their portfolios and capitalize on opportunities to maximize returns in today's dynamic and ever-evolving market environment.

The bottom line

Despite continued uncertainty over inflation, interest rates, and limited bank loan availability, we believe private credit continues to offer compelling investment opportunities, especially for investors seeking diversification and stable returns in volatile markets.

By capitalizing on the retreat of traditional banks, navigating competition in the upper middle market, and exploring attractive opportunities in European markets, investors can harness the unique advantages of private credit in today’s environment to achieve their investment objectives.

Furthermore, with the evolving regulatory landscape and emerging alternative lending platforms, we contend now is the time to seize the potential of private credit and position portfolios for long-term success in today's evolving economic landscape.