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Private Credit 

Will Caiger-Smith

Regular readers of this column may be wondering where David Brooke has got to over the past couple of weeks. He’s been out battling a nasty case of Covid, but is now back in the office and back on the beat. The Unicrunch will resume its regular schedule from next Wednesday — thank you for your patience.

The hype around private credit has been pretty constant this year, but even so, the past couple of months have felt like an escalation in terms of the sheer volume of announcements and launches. This is based more on vibes than objective data, but I’m not the only one who feels this way — there’s a reason people have been making jokes like this one.

One notable thing about this recent rash of new adventures in private credit is that many of them are collaborations between investment firms and banks. Wells Fargo is teaming up with Centerbridge, there’s a potential partnershipbetween Barclays and AGL, and Scotiabank and Sun Life are collaborating on a new high net worth network.

We could go on, but you get the point: just like private credit itself, these partnerships aren’t exactly a new idea (Oak Hill and BMO have had a direct lending tie-up since back in 2021, for example) but it’s becoming popular enough that it’s starting to feel a bit like a bandwagon. 

The other trend is for banks to push into private credit themselves, either by setting aside balance sheet for direct lending — like JP Morgan and Barclays — or by setting up or expanding their own direct lending teams. HSBC is a good example of this second approach. 

I’m over-simplifying here: there isn’t exactly a neat division between a bank setting up its own private credit business and doing a partnership with a third party, and there are multiple models in between those two extremes. Another model is out-and-out M&A, like Antares looking to buy Hayfin to expand its European presence (buyside firms like Man Group have also done this).

Each situation is different, and that’s kind of the point. 

The ‘why’ part of this private credit mania should be fairly clear by now. All the stars are aligning for private credit lately: high interest rates are juicing returns on existing deals (enough to make investors annoyed about hurdle rates), concerns around the denominator effect are easing, rich retail investors are under-allocated to the asset class, and banks — especially since the Silicon Valley Bank meltdown — are in the regulatory spotlight. 

It makes sense that banks want to maintain exposure to the clients that private credit firms serve, rather than losing it completely. The emerging logic is that banks are great originators of riskier debt, but for regulatory and financial stability reasons they’re not necessarily the most natural long-term holders of it; partnering with funds simply formalizes that complementary relationship.

That’s all well and good, but the ‘how’ hasn’t got that much attention. There are a million different ways these ventures could be structured and administrated day-to-day. Everyone’s got the same idea, but not everyone will have the same execution — the structural and operational side of things might well be the differentiator between who succeeds and who doesn’t. 

Investment banks are big and complicated. One thing to clear up right away is that many of them have asset management arms, and those asset management arms may have private credit funds; these are quite different from the private credit businesses that some of them are starting.

JP Morgan Asset Management, for example, is in the market right now trying to raise a $1bn fund to invest in private credit secondaries. This is a separate part of JP Morgan Chase & Co to the investment bank, whose DCM chief has been making a lot of noises about private credit lately after the bank set aside some $10bn for direct lending.

Lots of investment banks also have so-called balance sheet lending teams, which do a lot of the same kind of direct lending that private credit firms do (or that the private credit group of banks like JPM and Barclays might do) but don’t necessarily have the flashy new private credit branding that has become popular in recent years.

This might just sound like semantics, although sometimes these distinctions matter. The broader point, though, is that there is an array of different ways for talking about this stuff, and that each bank is its own beautiful and complex butterfly. 

To that point: it’s tempting to think that the way a bank is structured internally has no impact on client experience or the institution’s ability to do deals, but there are plenty of examples of how different organizational structures can (or could) lead to different outcomes.

One example is a big-picture thing: regulation. 

A lot of the banks with the biggest balance sheets — and by extension the most firepower to compete in private credit — are systemically important institutions and subject to more onerous regulation. That not only changes their economic willingness (riskier lending requires greater capital reserves, and greater capital reserves drag on profitability) but also subjects them to some hard-and-fast rules that decisively prevent them from doing some deals.

This is how one ex-banker turned private credit lender put it, talking about one of the year’s biggest private credit deals:

How much of a single position can a bank hold on their balance sheet? It's not $200m, and it's definitely not $500m. But that's table stakes if you want to be in the Finastra deal. You weren't getting a phone call if you couldn't write a $200m ticket. Of a $750m deal, realistically a bank is going to hold maybe $50m of that. And what if it's a non-pass credit?

Another example, which is much more in the weeds: bonus pools. 

Let’s say tour investment bank has built a team to do private credit, and has set aside some balance sheet for it. Does the private credit team share in the same bonus pool as you and your DCM colleagues, or does it have its own separate pool?

In our conversations with sources we routinely encounter both models, and there are good arguments for each one. 

Some say they should be separate, because the entire concept of direct lending (lending the bank’s own capital, and holding the loan on the balance sheet) is fundamentally different to the work of taking short-term risk by underwriting debt financings and then offloading those commitments to institutional investors. 

As the cliché goes: one is a storage business, the other is a moving business.

Others say they should be one single pool, because otherwise there’s less incentive for teams that are ultimately working with the same client to work together, share information, and present a united front when pitching clients. If your bank is getting into private credit to offer a full suite of solutions to private equity firms and avoid being disintermediated, segmenting the financial success of different teams kind of undercuts the ‘one team, one dream’ pitch.

Separate pools could also incentivize decisions that might not be in clients’ best interest. If you’re a banker in a firm with a direct lending unit, and your client is choosing between a high yield bond deal and a direct lending facility, you’re probably going to push harder for the bond deal because it will directly impact your team’s P&L and therefore your bonus.

As much as people talk about traditional syndicated bank lending as the ‘moving business’, there is an element of storage to it. Even if you’re not keeping your new client’s loan on the balance sheet, you’re definitely hoping you can hold on to the relationship to generate future fees.

The Twitter/X buyout financing is a kind of warped example of this, where banks were chasing the future Musk fee-stream and ended up holding the risk. That clearly wasn’t the intention — but it could have been if each bank involved had a partnership with a private credit fund that was more comfortable holding onto X’s debt for the long haul. 

Imagine that world: the banks’ relationships (with Musk) and underwriting resources (armies of analysts and associates to come in on the weekend, crunch numbers and put together pitch decks) could have won the mandate; the private credit firm’s balance sheet could then have taken down the debt, offering speed of execution; then, the banks could take care of all the fee-generating follow-on business from X and future Musk ventures.

This is how one banker we spoke to recently put it (’they’ refers to private credit funds):

They're very, very good at underwriting and owning and, you know, managing credit. But things like cash management, and who does the payroll, all those things are fairly boring products — but they're boring and annuity and low risk. That's the stuff banks like to do.

This list of ‘stuff banks like to do’ could probably have been a lot longer. There are many forms of follow-on business that are more lucrative than payroll and cash management AND that banks are far better placed than private credit firms to provide: for example, underwriting and distributing high yield bonds, which (unlike loans) are securities and thus have much more onerous disclosure requirements. 

Ultimately, the point of these partnerships is not just to make sure banks don’t get squeezed out of the leveraged loan market by private credit funds — it’s to turn those funds into a funnel for future investment banking and commercial banking relationships, which generate fees. 

But how do you navigate those relationships within the partnership? Who owns the client? In the hypothetical Twitter case above, who manages interactions with Elon Musk? Is it the banker that masterminded the pitch and won the mandate, or the private credit partner firm that holds the debt?

Arguably they both do, just in different ways: one is a capital provider, the other is more like a fixer, focused on tailoring solutions and marshaling resources. And the conventional wisdom would be that the bank owns more and more of the relationship as the company gets bigger and graduates to investment grade. But the point is that the organizational plumbing between banks and credit firms is likely to become more sophisticated as these partnerships bear fruit. 

Banks are already complicated institutions, and adding private credit partnerships to the mix will make them more so; it would be ironic if, in their efforts to remain a one-stop shop, they became so complex as to be less effective. 

Too much complexity could even invite more regulatory scrutiny — the very thing that birthed the rise of private credit in the first place. 

This article is part of our new service, 9fin Private Credit. If you're interested in a free trial, contact subscriptions@9fin.com

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