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Private Credit 

Shubham Saharan

Peter Benson

Anna Russi

Private credit is the hot thing on Wall Street today, and everyone wants a piece.

Last year, the headlines were all about private credit firms partnering with banks. This year, it’s about hedge funds increasingly vying to get access to the burgeoning asset class.

In the last few months alone, 9fin reported that Third Point is looking to raise its first direct lending fund, Viking Global has founded a private credit team, and Millennium Management is also exploring building out its own private credit arm.

For the new entrants, there’s a well-trodden path to follow, as a handful of firms have managed to carve a name for themselves in the private credit world already. Take for example Silver Point and TCW, both firms that have hedge fund roots and now have well-established private credit platforms.

Earlier this month, 9fin reported that Silver Point is looking to raise its third direct lending fund targeting $4bn, while TCW announced in May that it had partnered with PNC to expand its direct lending capacities.

But why shift into private credit in the first place? For many funds, it’s the opportunity to bolster returns and respond to investors clamoring for more cash, according to one head of hedge fund solutions at a bank.

“People are getting more greedy. There’s a massive change in expected returns and everyone wants more out of hedge funds. They’re looking at more options to generate the returns being demanded of them,” they said.

”There’s a lot of them trying to get into [private credit], and if you have the right structure, why not? But you have to be careful on how you deliver it,” they added.

The numbers show it: credit hedge funds were up 2.5% in Q1 2024, according to data provider Preqin. Meanwhile, direct lending funds were up 3% during the same period, Cliffwaters’ index shows.

Historically, that holds true as well. Private credit funds, including direct lending and other strategies, have exceeded the returns of credit hedge funds. Last year, for example, direct lending fund returns were 10.3% at the end of 2023 and mezzanine strategies returned 11.5%, according to Preqin's latest data.

Meanwhile, credit hedge funds returned 8.8% in 2023, the Preqin data shows.

But, there’s some threat of returns in private credit waning this year, as pricing compression continues to take its toll on private credit lenders focusing on both sponsor and non-sponsored transactions.

In order to invest and cash in on returns, funds first have to have cash to invest. For many of these new entrants, they’re coming at a time when the fundraising environment is harder than it has been in years.

Direct lending funds worldwide raised $33.1bn from the beginning of January to the end of May — less than a third of the sum raised in the first half of 2023, according to Preqin.

Direct lenders raised $210bn in all of 2023, down from $215bn in 2022, and $242bn in 2021, which was the record aggregate amount raised for the market.

For newer private credit managers, it could be a struggle to attract investor interest, even if they have a good reputation in other markets.

"The competition is that investors aren't going to invest in a fund just because the fund manager is well known. They're going to invest because of the track record of the team,” Barbara Niederkofler, a partner at Akin Gump Strauss Hauer & Feld, told 9fin. "It's very important to have that reputation."

Plus, there may be more scrutiny from LPs as to why some of these funds are entering the market in the first place, according to one private credit placement agent.

“What the LPs themselves are looking at is, first of all, why are they launching a private credit platform or product? Is it a defensive move to stop outflows?” they said. “And secondly, [LPs are] looking at [whether these hedge funds are] really investing in private credit investments that go into the fund or is it one of these more liquid trading of secondary credit strategies?”

It’s not a space meant for every firm, and there’s already some cautionary tales of what failed ventures look like.

There’s the recent example of Fidelity International, which let go of around 30 people as it exits European direct lending seven months on from launching its first direct lending fund.

Then, there’s the issue of deploying that capital and working with sponsors and lenders to do so.

There’s a myriad of different strategies that private credit encompasses, and to be sure, hedge funds' diverse portfolios could give managers a broader view of market opportunities. That would allow funds to adjust their strategies to meet investor expectations for returns, according to Dan Hunter, a partner at Schulte, Roth & Zabel.

“[Hedge funds] absolutely could have a competitive advantage,” he said.

Still, Hunter added, the higher flexibility to invest across the capital spectrum also comes with potential downsides, as some hedge fund managers have already seen when trying to invest in venture capital. “They just have to make sure that they don't get stuck upside down in the trades, like certain hedge fund managers did in venture capital,” he said.

But, there’s also some strategies in private credit that are harder to get into than others. Namely the traditional direct lending space, where sponsors are already often choosing from a laundry list of lenders with a proven track record of performing, the private credit placement agent noted.

“Anyone wants to start a plain vanilla direct lending fund from scratch needs their head examined because that train left the station 10 years ago,” they said. “This is not a time to launch a fund one with no track record. This is a time for consolidation in the direct lending space.”

There’s already a handful of mergers that point to that trend, and data shows that larger players already dominate direct lending.

Then there is the relationship aspect of private credit, where currying favor with a sponsor and playing nice with other lenders is of the utmost importance.

That’s not always the way that the majority of credit hedge funds are used to playing in public markets, where lender on lender violence is far more common than in private ones (recent maneuvers at Vista Equity-backed Pluralsightwere unprecedented in private credit).

“[Hedge funds] are not historically relationship driven,” said one director at an asset management firm. “Private credit is different, it’s built on relationships, on holding loans. It’ll be interesting to see how they build out their platform.”

Of course, there’s always the alternative, at least in the beginning of building a business, of simply buying loans that other firms have already originated.

As we’ve noted before, there’s a steadily developing secondary trading market for individual private credit loans, which can provide an inroad for new entrants.

Indeed, some hedge funds have already begun exploring the strategy, as roughly 19% of direct lending loan sales are transacted by hedge funds, according to a recent report by J.F. Lehman & Company.

Still, this type of secondary activity is usually not marketed widely, with lenders often only reaching out directly to one or two prospective buyers that they have relationships with, on an exclusive basis.

Plus, some market participants have noted that such secondary transactions are happening less frequently now, as private credit lenders are eager to keep hard-fought deals on their own books.

And for deals that happened in years past, many are reluctant to let go of paper that was priced on average 100bps higher than most direct lending deals today without a significant premium.

“We’ve had people reach out to us and we’ve passed [on selling the loan], or had instances where we asked for 100 or 101 [OID],” the director said.

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Hedge funds want in on private credit — but are they ready for it?

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