What do the auction house Sotheby's, the shapewear maker Spanx, and the company behind Fender guitars have in common? They've all borrowed money from firms that lend like banks, earn interest like banks, and work with clients like banks — but aren't banks.
For a midsize company, going to private-equity firms and other money managers — also known as nonbanks, shadow banks, or alternative asset managers — is an increasingly common way to borrow cash.
Traditional lenders, including Bank of America and Wells Fargo, have pulled back on issuing loans to companies since the Great Recession, when new regulations required banks to hold more capital on their balance sheets to guard against loan losses. But businesses will always need to borrow cash to run. Investment firms such as Blackstone, The Carlyle Group, Apollo Global Management, and Ares Capital Corp. have pushed aggressively into the private-debt market to take advantage of that need.
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It's been a smart bet for money managers. PitchBook data shows that private-debt funds returned 4.2% last year as the S&P 500 lost 18% and investment-grade corporate bonds lost nearly 16%. A Morningstar index used as a proxy for private debt is now on track for its best year since the Great Recession.
The many thousands of companies taking on private debt — rather than bank loans or issuing corporate bonds — are setting private-equity firms up to be more powerful than ever. The $1.75 trillion market often charges companies higher interest rates than they might get at a bank because the firms take on risks that banks can't or won't.
"The reality is that for a bank to write these loans, they have a significant capital cost," Sean McKee, a national practice leader at KPMG who advises asset managers, said. He said that banks wouldn't stop lending to middle-market companies entirely, but they'd been exiting the space and focusing more on bread-and-butter services, including mortgages, credit cards, and auto loans.
Investment firms are eating into banks' long-held position as the main source businesses tap for cash. It's a staggering shift in who holds the power to lend to companies and make money on lucrative interest payments.
Private-credit managers' funds and their big institutional investors, such as pension funds, are intertwined with the successes and failures of more and more companies; companies often pay up for access to loans they might not otherwise get with traditional lenders. Managers say they're helping support the economy, offering businesses much-needed capital. Because of fewer regulations, direct lenders can also customize the sizes and terms of their loans in ways banks can't.
Still, as expensive interest payments to private-investment firms weigh down a growing number of businesses across industries and as funds must deal with problems in their portfolios, some analysts and executives say a growing shadow-banking system poses risks to the wider economy. Weaker companies would ultimately impact investors in those pension funds, endowments, and other big pools of capital.
Scott Gockowski, a senior manager at Casey Quirk, Deloitte's investment-management consulting practice, said that despite low defaults, rising rates could leave unprepared companies vulnerable. "That may get to unmanageable levels in some areas, which could lead to defaults and ultimately losses in the portfolios," he said.
Most private debt has interest rates that move in concert with benchmark rates, climbing rapidly over the past two years, a win for lenders that can morph into pressure for some borrowers.
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"The pullback from commercial banks and the tighter credit conditions have opened up that opportunity even more significantly for us," Tim Warrick, the group head of alternative credit at Principal Financial Group's $507 billion asset-management arm, said.
Warrick, whose team oversees $10 billion in private-credit assets and focuses primarily on the lower-middle market, said companies getting financed today are in more stable industries such as software and parts of healthcare that offer steady cash flows. Like other investors, he also favors companies under the umbrella of "'break-and-fix' business models," including plumbing and electrical services that are consistently in demand and have reliable customer bases.
More resilient businesses, such as software companies that sell their platforms to other companies and groups rather than to consumers, are the ones getting funded, rather than those more vulnerable to economic cycles, Spyro Alexopoulos, the cohead of direct lending at the private-credit manager Golub Capital, said.
"While the economy and the performance of our underlying borrowers have been very strong — actually, surprisingly strong — I think there's still discomfort around where the consumer is headed," Alexopoulos said. Golub has experts on staff who specialize in helping companies in financial trouble, but right now, they're underused. "We were prepared for worse, earlier, and we haven't seen it yet," he said. "That may have to do with the type of portfolio that we've been curating versus others. But thus far, we haven't seen the stress. We would expect some at some point."
Private-debt managers say they oversee strong underwriting standards and due diligence on companies before committing capital — the basis for any prudent debt investment. That's doing little to convince critics that the risks of private debt's rapid growth to companies, funds, and their investors are under control.
Andrzej Skiba, the head of US fixed income at RBC Global Asset Management, warned of floating-rate-debt concerns in a July report: "Funding costs are crippling to private-debt portfolio companies." In May, the Federal Reserve said that the financial-stability risks private-credit funds pose were limited but that "the sector remains opaque" and assessing default risks is difficult. Colm Kelleher, the chair of the board of the financial manager UBS, said during a conference in November that he was concerned about the growth of the private markets in the past decade and that the next financial crisis would likely be in the shadow-banking sector.
Data providers and asset managers still expect the global debt market's growth to multiply.
BlackRock, the world's largest asset manager, which has expanded its private-credit platform, projects the global market will hit $3.5 trillion by 2028. Outside financial services, those growth expectations have led to new business for other areas, such as the legal industry.
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Big law firms, including Ropes & Gray and Proskauer, have been adding lawyers focused on advising private funds to their practices. Lawyers such as Proskauer's Justin Breen have been among the go-to attorneys in the private-credit space. Breen, who advises clients including Ares, Bain Capital, and Churchill Asset Management, leads Proskauer's global finance practice and focuses primarily on counseling private-credit managers.
There's a lot of money in the business of negotiating loans outside the banking system. The private-capital lobby, which has long advocated for private-equity managers, wants to keep it that way for their members' growing private-credit arms.
This fall, the industry's main US trade association, the American Investment Council, released two reports advocating for private-credit managers and sent them to journalists. Drew Maloney, the Washington, DC power broker who has been the group's president and chief executive since 2018, said in one of the reports that private-credit firms had "dramatically increased the chances for struggling companies to get back on their feet" because of the firms' ability to take on more risks and work together with borrowers.
Milwood Hobbs, the head of sourcing and origination at Oaktree Capital Management, said some borrowers would struggle with increasingly expensive debt, especially those that borrowed when rates were much lower. "This creates a lot of strong opportunities for private-credit providers without legacy portfolio issues to step in and support performing businesses navigating a more challenging economic environment," he said.
Firms often say that they have the advantage of working closely with portfolio companies if trouble hits and borrowers can't make payments. Denis Rudnev, a director at S&P Global Ratings, said that during the volatility of the pandemic, lenders have offered borrowers temporary relief if they need it, such as amending or extending loans, using so-called "payment-in-kind" interest arrangements, or waiving certain conditions.
"We're seeing more of that now, but those types of strategies haven't really been tested in a prolonged higher rate environment. The duration of elevated interest rates will be a key focus, especially for this segment of the market," Rudnev said. In November, his team published a report stress-testing 2,000 middle-market companies with private-debt financing and found that while default rates remained low, companies' credit metrics such as cash flow and liquidity could reach "precarious levels" under moderate- or severe-stress scenarios.
Firms say they make ample information about their private-credit funds publicly available so investors can see whether the investments are appealing. Entities known as business-development companies — a common, tax-advantaged way for firms to offer private-credit investments — must file public disclosures with regulators. Publicly traded business-development companies' management teams hold earnings calls with Wall Street analysts.
Still, regulators say private-credit funds manage five times the assets as business-development companies do, and the information they must disclose only goes so far. The Federal Reserve said in its financial-stability report in May that comprehensive data on the terms of private-credit deals and borrowers "are lacking."
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