Private Credit 101

March 2024

Private credit, specifically direct lending, is gaining popularity in investor portfolios. With all of this talk about private credit strategies, how about a little refresher?

What is Private Credit?

Private credit refers to debt privately originated by an asset manager without the intermediation of a bank or traded on any public market. This direct approach can achieve greater efficiency, confidentiality, and certainty of closing for the borrower than borrowing from a bank. The lender typically benefits by securing tight financial protections and higher yields. Unlike public debt, rating agencies do not rate private credit loans.

There are various types of private credit strategies across various segments of the market. Across market segments, private credit can span the capital stack of small businesses, up to very large corporations.

US Corporate Hierarchy

For illustrative purposes only.

What Are the Different Types of Private Credit Strategies?

  • Direct Lending: Direct lending loans are made to a corporate borrower for business expansion, acquisitions, or refinancing. These loans are generally senior in the capital structure (first-lien), however, direct lending can also be offered as subordinated debt, or unitranche, which combines different tranches of debt into a single loan facility. These loans are generally structured as floating-rate and tend to be issued to sponsor-backed borrowers (private equity-owned businesses).
  • Mezzanine Debt: Mezzanine debt typically reflects private credit and private equity characteristics. It consists of loans that are subordinate in the capital structure and have additional features, such as preferred equity, to compensate investors for their investment risk. These loans are also typically provided to sponsor-backed borrowers (private equity-owned businesses).
  • Distressed Debt: Distressed debt consists of loans to distressed companies in bankruptcy or on the precipice of bankruptcy. These loans can span the capital stack as senior secured, subordinated, or mezzanine debt. The purpose of these loans is to lend a borrower money, usually at a high interest rate, with the intention of restructuring the company to become profitable.
  • Special Situations: These loans are typically made to distressed companies or those about to undergo a material event, with the intention of gaining control of the company. Similar to distressed debt, special situation loans can span the capital stack.
  • Real Estate Debt: Debt used for real estate development or investment in existing real estate assets. Real estate debt can span the capital stack.
  • Infrastructure Debt: Debt used for infrastructure development and investment in existing infrastructure assets. Infrastructure debt can span the capital stack.

At PennantPark, within our Senior Debt Strategy, we focus on Direct Lending. These debt instruments are directly originated first-lien loans in the core middle market. Our Senior Debt Strategy targets profitable, growing, cash-flowing companies with $10-$50M in earnings across five primary sectors: healthcare, government services, software & technology, consumer, and business services. Our direct lending deals are structured with floating-rate yields, over a specified reference rate (usually LIBOR or SOFR), at the top of the capital structure, with a minimum of two financial covenants.

If structured properly, direct lending strategies have the potential to generate returns similar to, or higher than, other credit investments, with less risk and less volatility. Below, we outline the three primary reasons that investors are increasing their allocations to direct lending.

Why Invest in Direct Lending?

Investors are increasingly allocating to private credit, and direct lending is gaining particular attention. According to a survey by Mercer Investments and CAIS, 98% of the 260 participating financial advisors were already investing in private credit, and 68% planned to increase their allocations over the next 12 months1. What are the expected benefits?

  • Principal Protection: Since 2005 direct lending has had a ~50% lower annual loss rate1 compared to public high-yield loans. Additionally, given its senior place in the capital stack, direct lending has a lower risk of principal loss compared to private equity. Furthermore, direct lending typically consists of a single lender and borrower instead of a group of multiple lenders, as seen in the public markets. This direct collaboration often results in more efficient workouts following a payment default, which can lead to greater recovery rates.
  • Premium Income Generation: Direct lending loans typically offer investors higher yields than traditional fixed-income investments to compensate them for the illiquidity risk they take on (the inability to trade the loan in the public markets). Additionally, most direct lending loans are structured with floating rates. Floating-rate loans will provide higher yields than traditional fixed-income investments, regardless of the interest rate environment. As such, direct lending can offer investors consistent, predictable, current income.
  • Diversification: Given its low correlation with the public markets, direct lending has historically provided diversification benefits. Unlike traditional fixed-income securities, which decrease in value when rates increase, direct lending typically benefits from increased rates, as the floating-rate yields rise in tandem. Furthermore, given the illiquid nature of direct lending, it has not historically been subject to the volatility of the public markets. Direct lending can also offer supplemental diversification benefits from other private credit strategies within a portfolio.

1 Why Private Credit Is the Alternative Asset Class Everyone Covets | February 2024

Historical Yields Across Fixed Income and Private Credit

Note: Past performance is not necessarily indicative of future results. Invested capital is at risk. Volatility is measured using standard deviation.

  1. Data as of 9/30/2023. All of the quarterly standard deviations are then annualized. “Private Credit” and “Senior Private Credit” are represented by the Cliffwater Direct Lending Indices. “Leveraged Loans” is represented by the Morningstar LSTA US Leveraged Loan Index. “US High Yield” is represented by the Bloomberg US Corporate High Yield Index. “Investment Grade Bonds” is represented by the Bloomberg US Aggregate Bond Index. The indices presented are not subject to fees or expenses and it is not possible to directly invest in any index presented. Unlike the indices presented, PennantPark could employ leverage, which will increase the volatility of PennantPark’s investments and will magnify the potential for loss of amounts invested.
  2. Source: BofA Q4 2023 Chartbook – 2024: A Foundational Year, BoFA Global Research. “Investment Grade Bonds” is represented by the ICE BofA AAA U.S. Treasury Index. “High Yield Bonds” is represented by the ICE BofA High Yield Cash Pay Index. “Broadly Syndicated Loans” is represented by the ICE BofA Global Broad Market Corp (Hedged) Index. “Middle Market Private Credit” is represented by the Cambridge Associates Private Credit Index.

PennantPark Contacts:

Managing Director; Head of Private Wealth Distribution
Senior Associate; Investor Relations & Fundraising

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