Private credit promises bespoke capital

We have seen this before: In the 1980s, the expansion of the high-yield bond market helped unleash a capital funding wave of leveraged buyouts as private equity flexed its role in markets. Further transformations followed that inflection point when broadly syndicated and leveraged loan markets rose as a source of debt capital for predominantly sponsor-backed companies. As originators and arrangers sought to meet the debt capital needs of a wide expanse of borrowers, the growth of the asset class resulted in its eventual commoditization and the establishment of market standards. 

Private credit growth over the last decade reflects the next natural progression of this evolution. Inherently more flexible than their predecessors, private markets are already seeing lenders try out new debt structures and terms to fit borrowers’ investment profiles and preferences.  

With fewer lenders involved in a transaction, private credit can offer a lender flexibility to provide more bespoke solutions for a borrower. This innovation may provide fertile ground for new or innovative instruments. However, not all financial innovations work out for the investor, and it is ultimately up to the investor to assess if a new product offers fair compensation for its risk.

Recent uncertainty in the financial markets has contributed to a slowdown in primary market issuance and M&A activity, creating new opportunities for private credit growth. As lenders look to unlock today’s funding challenges, they may be establishing new channels for debt capital to reach corporate borrowers, providing funding for investment funds, infrastructure and asset-based finance. Charting this path forward, a future defined by diverse and disparate funding solutions may mean more opportunities for borrowers. However, it also raises the risk of fragmenting markets, where less commoditization and more illiquidity could shrink the pool of potential buyers for a more specialized instrument. 

As we have seen in the past, the balance in leveraged finance markets often tilts toward private credit when markets are uncertain or volatile. While high-yield and broadly syndicated loans may have larger scales and offer tighter pricing, private credit can offer more flexibility with more certainty of execution. 

Assets under management of private credit funds total nearly $1.7 trillion globally, a considerable share of which is dry powder, waiting to be deployed. With more than $450 billion in dry powder — including nearly $150 billion earmarked for distressed debt or special situations — private credit is poised to expand its footprint in corporate lending. Where uncertainty and volatility can lead to sudden slowdowns in primary market activity for bonds and broadly syndicated leveraged loans, the certainty of execution that private credit offers, coupled with its accumulated dry powder, demonstrates the capacity for private credit growth as an integral source of funding for leveraged finance in the coming years. This shift marks a sea change in credit markets.   

In contrast to private credit, bond markets are largely regulated with established infrastructure, where banks underwrite and facilitate trading in a transparent and organized secondary market. The rise of broadly syndicated loans marked a step away from this highly regulated and organized bond market because broadly syndicated loans are a private placement instrument. The evolution of the relatively robust and liquid secondary market for broadly syndicated loans is largely due to the continued presence of banks acting as arrangers on these large transactions.

Private credit growth, however, marks a significant progression toward a decentralized source of debt funding, where fully private placement transactions originate through an alternative asset manager. With little to no secondary market for trading, these instruments are treated as buy-and-hold assets that may be suited to long-term investors, but they lack the liquidity of bonds or broadly syndicated loans. 

At its heart, private credit is a bilateral agreement between a borrower and a single lender, or perhaps a small club of lenders. With fewer parties involved, the private credit arrangement offers more flexibility of terms, such as payment-in-kind, recurring revenue loans and higher leverage limits. But one lender’s comfort in offering these terms to a borrower may not be shared by other investors, and the uniqueness of the instruments heightens the barrier to trading. 

Adding to the challenge of trading, private credit borrowers encompass a large pool of small to medium-sized enterprises; tranches tend to be smaller and more difficult to scale, with fewer disclosures that are possibly more complex and have more varied terms; and the instruments lack a system of identifiers.    

The quantity and diversity of borrowers in private credit make the job of identifying and comparing credit opportunities even more challenging because the numbers in private credit are vast. In North America, for example, there are nearly 1,700 companies that are publicly rated speculative-grade (BB+ or lower), but the number of borrowers for which we have a credit estimate is close to double, at over 3,100. These credit estimates only represent the slice of the market held by middle-market collateralized loan obligations, which provide a source of funding for private credit lending.

As the pendulum swings toward private credit growth, more borrowers may turn to it for funding, flexing private debt to refinance public debt. The private credit market stands to grow as a result, with more borrowers and more varied instruments becoming available. While opportunities for better pricing will encourage borrowers with broad investor appeal to refinance private debt in the broadly syndicated and high-yield bond markets, the ranks of private credit are likely to expand as smaller or more specialized borrowers may have few alternative funding options.  

Private credit’s flexibility helps it to fit the needs of debt capital for many smaller borrowers. But this creates a broad pool of credit instruments, which individually may have relatively few potential investors. 

Technological innovations may provide investors with the tools to navigate these challenges. AI agents, responsibly governed, could enable managers to sort through a greater volume of borrowers and potential investments, for instance, and tokenization could provide new ways to trade or distribute private credit instruments. 

Although alternative asset managers are playing an increasingly central role in financial markets, as managers of both private equity and private credit, funds are also increasingly turning to private credit for debt funding. Lagging M&A activity in recent years has provided fewer opportunities for private equity to exit investments and return capital to limited partners. Meanwhile, private equity fundraising has slowed, creating a challenge for launching new funds. 

While different tools for fund-based finance are already well established, private credit is adapting to fund needs. 

The sources of fund-based finance vary, and private credit is establishing its niche. While banks largely dominate the market for subscription lines of credit — mainly used during the early years of the investment period and backed by uncalled capital commitments from limited partners — the net asset value loan market, secured by the funds’ assets and used by funds in a later stage of their lifecycle, is a segment that has seen tremendous private credit growth in recent years. 

The growth of assets under management in this segment has been supported by funding from insurance companies and credit funds investing in this space, as well as demand from private equity funds for new sources of funding.   

Private equity set a record for exits in 2021, but exits fell off dramatically in 2022 amid rising inflation and a growing buyer-seller divide. The pace of exits has not improved significantly since. Global private equity fundraising declined in 2024 for a third consecutive year as the lack of exits continued to put stress on the private equity fundraising cycle. This trend is slowing the pace of commitments to new private equity fund launches.

This slowdown in exits and capital raises is pushing private equity funds to use more debt at the fund level to fund portfolio investments, for instance, or to provide liquidity to limited partners. Private equity funds may also raise more debt through dividend recaps or to fund continuation funds, which acquire the positions of aging funds. With a rising backlog of unsold positions, the assets under management of continuation funds are surging. Overall, leverage in fund-based finance is increasing through funds’ use of a growing number of different types of fund financing options, with private credit lenders gaining share in this market.

Funds are now finding ways to unlock liquidity through new and varied types of financings. This may lead to faster ramp-up periods, more exit options and possibly higher leverage for funds going forward. 

Private credit growth into fund-based finance is part of a broader push toward asset-based finance (ABF). Though fund-based finance and ABF may have evolved independently, they are increasingly grouped together in private credit portfolios where investors are seeking assets that offer predictable contractual cash flows. ABF encompasses a broad array of assets, from funds to consumer receivables, as well as more esoteric assets. Given the flexibility available to arrangers of private credit, new structures are emerging that blur the lines between investment funds and structured finance. Funding is evolving as investment vehicles take a page from the playbook of securitizations, including splitting credit risk in tranches.

Opportunities in ABF may have risen in response to a public asset-backed securities market that has become well-established and defined, often with homogenous collateral pools and more established originators. By contrast, the private credit market for ABF may see more variation in collateral and concentration limits and be ripe for experimentation. 

This expansion into ABF further demonstrates how private credit offers fertile ground for financial innovation. But rapid advancement and experimentation are swiftly adding to the potential for market fragmentation. A shifting mix of collateral and structures is ramping up the complexity of instruments and the variety of assets within portfolios. 

The growth of private credit reflects the next natural progression of a credit journey that goes back at least to high-yield and broadly syndicated loans. With flexibility through cycles and accumulated dry powder to deploy, private credit appears positioned for further growth in capital markets as a tool that lenders can provide to meet borrowers’ needs in corporate, fund-based, infrastructure and asset-based finance. 

While this expansion is leading to a larger private credit universe, it is a market in which trading and liquidity are restricted by the unmapped, fragmented nature of the assets, leverage is higher, and complexities are unseen. New technology in the form of AI agents may offer investors greater capacity to navigate this universe, but it could also lead to unintended consequences. Financial markets are heading in a direction where credit is more bespoke to meet unique funding challenges. New technologies that can help bring transparency and foster liquidity provide an essential stepping stone to the future of capital markets.