The roots of private credit are as old as lending, but its core business and practitioners have evolved over time.
This is true for individuals and businesses of all sizes, but especially for small and midsize companies that often need leverage to finance specific strategic needs, such as expanding into a new market or acquiring another company.
“All businesses, regardless of their size, need to be able to access leverage in order to grow,” said Jarrod Phillips, Chief Financial Officer of Ares Management.
Financing the Mid-Market Segment
The BDC Act created Business Development Companies, or BDCs. Their mandate was to extend credit to small and midsized businesses, privately owned and operated companies that are a pillar of the economy and account for most of the employment. At the time, some of these companies were struggling, but most operated solid businesses in local markets and communities. Yet they couldn’t readily access the capital they needed in the wake of the 1970s recession, as banks pulled back from market segments deemed too risky, cumbersome, or just not profitable enough to merit competitive resources. Recognizing this looming “liquidity gap” and the issues it created for economic growth, Congress stepped in.
It took time, but BDCs changed the market. On the demand side, they gave small and midsized businesses access to liquidity that they needed to grow. On the supply side, for the first time ever, BDCs as a financial product—publicly traded, regulated, closed-end direct-lending funds—allowed individual investors access to a dynamic private credit market that offered diversification from publicly traded stocks and bonds.
As BDCs matured and expanded their direct-lending activities, traditional banks found a new opportunity in lending money to BDCs, which were a finite and manageable set of known market players who required leverage for their own financial operations and strategic growth. Through this symbiotic relationship, banks effectively retained access to the return profile of these private loans without having to maintain the extensive infrastructure or bear the same granular risk of lending directly to hundreds of individual businesses. Instead, they lent to the BDCs, which, in turn, managed a diverse portfolio of numerous underlying loans. This arrangement reduced the banks’ overall risk exposure while still allowing them to participate in the private credit market’s attractive returns.
The Next Stage of BDC Evolution
By the early 2000s, the BDC industry had matured and was reaching another level of growth. Working with regulators, specifically the SEC, the industry managed to win a broadened mandate.
Again, the supply and demand dynamics changed. These larger BDC loans allowed more and larger privately held companies to participate in the private credit market, just as traditional banks once again seemed more reluctant to make direct loans. Following the Great Financial Crisis that began in late 2007, banks faced more scrutiny, regulation, and capital requirements. Their retreat from the private credit market created a new opportunity for BDCs, which now could handle those larger deals.
In many ways, the BDCs appeared to have evolved to meet the challenge. They regularly publish a schedule of investments that includes every single loan they make. They have long-term committed capital that allows them to avoid potential duration mismatches. “Unlike banks, where deposits can at any time be moved out of the bank, forcing sales of other assets, BDCs have a matched duration, in many cases, on their leverage, or they have that permanent equity that they’re lending from,” Phillips said.
Demystifying Private Credit is a new series that explores different often-misunderstood facets of the private-credit and direct-lending markets.