The future of private debt: Eaton Partners on the evolution of debt

The private credit asset class was historically dominated by mezzanine, subordinated and distressed debt.

But since the global financial crisis caused a pull-back in bank lending, private debt has extended into several other attractive and global direct lending strategies across both sponsored and unsponsored dealflow. This includes various senior lending, uni- tranche, preferred equity, asset-backed lending, and specialty or industry lending strategies.

As LPs have become familiar with vanilla assets like senior corporate lend- ing, many are broadening their risk pro- file to specialty assets. Examples include trade finance, litigation finance, munici- pal special situations, insurance risk, tax liens, appraisal rights, music royalties and industry- or thematically-focused asset backed credit. Banks or large generalist credit platforms tend to shy away from such strategies, which require highly specific expertise. Thus, barriers to entry, and for dealflow, are high. A growing number of managers, particularly in the US and Europe, are raising considerable amounts of capital in these less crowded credit areas.

As with corporate lending, customised investment structures here are paramount, as is particular financial and operating expertise. Niche credit areas are far removed from both vanilla and liquid financial markets, and generally are better insulated from economic shocks. Speciality credit products are also often short-dated, which provides for a defined maturity profile and greater return certainty and timing, while allowing LPs more flexibility around re-allocations.

Alternative formats and vehicles for private credit investment are also on the rise. Several major brand managers have formed public or private business development companies for credit. Private BDCs in particular are an interesting alternative to a typical closed-end fund structure. A private BDC, similar to a closed-end fund, is designed to provide growing companies access to capital. However, private BDCs can access public markets and file for a public listing. A private BDC offers the ability to do US loan originations without US tax at the BDC and offshore investor levels.
Private BDCs are also generally more fee efficient for LPs on a blended pre- and post-listing basis. Several leading LPs, such as The Regents of the University of California and The State of New Jersey Common Pension Fund have made large commitments recently to private BDCs. We are also seeing an expansion in the type of LPs who are allocating to private credit. Traditionally, private credit LPs were state and corporate pension funds, insurance companies, and banks that needed further yield for liability matching.

Today, these LP types have been joined by sovereigns and other international LPs, as well as some family offices, endowments and foundations. Wealth management platforms and high- net-worth feeder vehicles are also driving some of the new demand, most notably for branded managers. Notable and large LPs increasing their exposure to credit include TIAA-CREF, NJ Investment Council, FMO, KB Insurance, African Development Bank, Alaska Permanent, Arizona Public Safety, Guardian Life, DEG, BJC Healthcare and Cathay Life.

It is obvious why these and other LPs are attracted to private credit – for diversification, high risk-adjusted returns, non- correlated cashflows, and a reliable income stream. As a broader range of private credit strategies, formats and vehicles becomes available, LPs, focused on quality and differentiation, are moving away from tradi- tional fixed income investments in a credit product marketplace that is increasingly compelling and proven.