By John Hintze
Private-credit funds have long supported middle-market businesses, typically providing debt below banks’ senior debt in a borrower’s capital structure. Since the pandemic, however, private credit has increasingly lent at the senior level and encroached on other traditional bank markets, raising questions for banks about whether the shift is cyclical or a more permanent one that requires rethinking their own business models.
The IMF Blog reported that in 2023 the private credit market topped $2.1 trillion globally in assets and committed capital, with 75 percent of that in the U.S., where its market share is nearing that of syndicated loans and high-yield bonds. With abundant dry powder in reserve, private credit has started encroaching on banks’ traditional territories in potentially worrisome ways.
“Private credit is going more mainstream,” says Sayee Srinivasan, chief economist at the American Bankers Association. “Before it was at the margins, doing junior debt; as bank regulations cause banks to exit or shrink their footprints, private credit is stepping into the vacuum.”
That vacuum has grown as larger U.S. banks anxiously await the banking regulators’ proposed Basel III “endgame.” They are anticipated to raise capital requirements for those banks by an average of 2 percent on their risk-weighted assets, a potential outcome prompting banks to shy away from providing riskier, more capital-intensive products.
Banks tend to adjust their business models and capital allocations in anticipation of implementing new rule proposals, Srinivasan says, and they have started shrinking their credit businesses. Private credit has stepped in to fill the gap, he adds, while banks have continued to provide ancillary services such as FX transfers, derivative hedging and treasury management.
The Basel rules would directly impact only banks with $100 billion in assets or more, but smaller institutions should track how the issue unfolds, as well as regulatory work on liquidity. “We don’t know where the banking agencies will land on the new liquidity requirements they’re working on, but it’s fair to presume that there will be a new set of restrictions on the sub-$100 billion banks, this time on the liability side of the balance sheet that will constrain what they can do on the asset side,” Srinivasan says.
Fitch Ratings says the portfolios of business development companies, or BDCs, which provide private credit to middle market companies through a public company structure, are now 75 percent of first-lien debt, a market that traditionally has been dominated by banks.
“In certain circumstances, BDCs might do a first-lien loan and carve out a top ‘super senior’ piece and have banks participate,” says Meghan Neenan, head of North American nonbank financial institutions at Fitch, which rates 25 BDCs.
Neenan said that the pending new capital requirements will likely spur more partnerships between banks and private-credit providers, allowing the latter to provide most or all of the credit and banks to maintain relationships with the borrowers and provide ancillary services. She notes the strategic relationships between banks and direct lenders, such as the one announced in September 2023 between Wells Fargo and CenterBridge Partners. It enables CenterBridge, through its Overland Advisors BDC, to provide senior secured loans to the banks’ vast array of middle-market clients.
David Konrad, a managing director at Keefe, Bruyette and Woods covering the largest banks, says that private credit providing the loans becomes more attractive to banks, even when it is senior debt, as the borrower’s credit risk increases.
“Funded debt-to-EBITDA north of four times would probably shift over to private credit,” Konrad says, adding that “partnership” may be too kind a description of the relationship between the two types of lenders, since in some cases borrowers have tapped private credit for loans their banks wanted to provide. “It’s partnering largely to meet customer demand, enabling banks to keep the relationship when the credit risk doesn’t meet their risk appetite.”
The question for banks is whether this type of relationship is cyclical, driven in part by high rates that have pushed some credit risk beyond banks’ comfort level, especially with a potential recession on the horizon, or if the change is more permanent.
Private credit does offer borrowers several advantages, including more flexibility compared to regulated banks as far as leverage and other deal terms. And for large loans it offers greater certainty of pricing compared to syndicated deals, in which multiple lenders must determine pricing, as well as a faster close and features such as paid-in-kind interest.
On the other hand, private credit is more expensive. Where all-in bank rates may hover around 7 or 8 percent, private credit is well into the double digits, Srinivasan says, adding that if rates stay higher for longer and the yield curve steepens, banks may bounce back and become more competitive.
In fact, while over the last few years private credit has captured an increasing portion of lending to large, leveraged corporate borrowers, the syndicated loan market had a blockbuster first half of 2024, originating more than $630 billion though mid-June, according to the Loan Syndications and Trading Association. However, 90 percent of the transactions were refinancings or repricings, rather than new deals fueled by M&A or leveraged buyouts and were driven in part by banks offering more competitive pricing.
“Some borrowers have refinanced in the syndicated loan market because banks have offered to lower their interest rate by 100 basis points or more,” Neenan says, adding that others have opted to stay with their direct lenders.
So far, private-credit providers have yet to compete for banks’ ancillary, often fee-based banking products. But they have started to move into lending markets traditionally dominated by banks, liked asset-backed finance, which includes consumer credit and equipment financing, Neenan said.
Over the years banks have sought to increase their fee-based businesses as a way to diversify earnings, and should a direct lender take over the credit element today, the bank will want to continue offering those products. Over the longer term, however, banks may find their businesses unsustainable if they forfeit their core credit products to direct lenders, Srinivasan says. “Over time, a bank might even get disintermediated from that whole process,” he adds.
More immediately troublesome for smaller regionals and community banks lending in a limited metro area is when private credit swoops in and pulls away key borrowers.
“We’ve been hearing a lot of that in the context of the medical services and hospital businesses, where there has been so much consolidation fueled by private-equity firms, with the help of private credit,” Srinivasan says. “A larger bank losing business to private credit can usually handle it, but for a small bank it’s a major loss of an opportunity with a local business.”
John Hintze frequently writes for the ABA Banking Journal.
