Watch: Private credit growing pains – a practitioner’s discussion

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Private credit has been one of the fastest-growing alternative asset classes for the past five years. This brings its own set of challenges related to complexity and how organisations can scale with increasing investor interest.

With private credit AUM surpassing 1.6 trillion in 2022, exceeding all industry predictions, how are organisations addressing the complexity and scalability challenges related to this exponential growth? How are the managers adapting within the private credit class to ensure continued strong performance?

I had the opportunity to moderate a closed-door conversation with industry experts to assess these challenges and budding opportunities.

These experts included John Phinney, chief executive of Convergence Capital; Jess Larsen, founder and chief executive of Briarcliffe Credit Partners; and Drew Phillips, partner and chief operating officer at Atalaya Capital Management. Together we explored how private credit has matured into an industry worth USD 2.6 trillion and the opportunities and challenges ahead.

How the private credit market is evolving

Private credit is one of the fastest-growing asset classes in the spectrum of alternatives, so I began by asking how the industry had changed.

"Over the last five years growth has been explosive," said Phinney. He added that when he started out in the 1990s, private credit was a diversification play - a vehicle for additional uncorrelated returns. Now the number of advisers in the space has grown from 500 to 2,500 and 15,000 funds are offering various forms of private credit.

"When you look at the alternative growth space in general, compounded annual growth rates over the past five years range between 6% and 8% on funds and assets," he said. Now, he says, credit is up 40%.

There were significant opportunities for service providers and other market participants to help advisers and general partners (GPs) in private credit work better.

Larsen said that before the US introduced the 2010 Dodd-Frank regulations in the wake of the financial crisis, private credit was really about distressed debt and mezzanine finance.

"Up until maybe a couple of years ago, private credit was really all about direct lending," he said. While direct lending remains the core of private credit, limited partners (LPs) now seek more uncorrelated strategies.

"We're talking probably specialty finance, bank lending and a lot of different and interesting strategies. That's what LPs are demanding right now - uncorrelated, strong returns from private credit," he said.

Phillips said the business's maturity meant private credit had become more competitive and faced both fee and regulatory pressure. This had brought much stronger demands from LPs on due diligence and a trend towards looking at managers holistically.

Challenges and success in private credit

Larsen said that the cost of setting up a private credit fund, as well as the complexity and regulatory environment, had become increasingly intense and difficult.

"It's not as easy for someone to come in and set up a fund as it was potentially even five years ago," he said.

Phinney said the cost of running firms was "brutally complicated" and did not lend itself to scale. The complexity of operations brought greater risk of error and failing to meet investors' reporting requirements.

How will rates, regulation and inflation affect future returns?

I asked the panel about the future, given that private credit has not gone through a cycle of rising interest rates or inflation, or even a war in Europe.

"First and foremost, a lot of people would conclude that Covid showed private credit is pretty resilient," said Larsen. "We came out of the Covid period with very strong private credit and we continue to grow."

Phinney warned there were 341 pages of Securities and Exchange Commission (SEC) recommendations that could add expenses and affect profitability within the industry.

"I'm very fearful that the regulators, not just the SEC, are going to issue some of these rules and this will have a pretty sharp effect on profitability returns and hurdle rates will have to go up," he said.

However, Phillips argued that regulation might help by providing standards, transparency and consistency. Larsen thought a stricter regulatory environment would aid fundraising as it would give the asset class credibility.

We also discussed how outsourcing can assist with the complexity of private credit.

Phillips said both the industry and service provider communities were maturing: "That creates a little bit of optionality to think about what's in-house, and what's outsourced. What do you build and what do you buy? Technology has really helped make that easier."

The future of the private credit market

The panel concluded that private credit would continue to grow robustly in the face of inflationary and regulatory headwinds. The service provider sector would evolve to meet fund management demands.

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How Intertrust Group can help with private credit management

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