• The growth of direct lending, or private credit, has created what we believe is a beneficial ecosystem for borrowers, asset managers, and investors. It has expanded financing options for corporate borrowers and provided asset managers with opportunities to find value.
• While private credit has characteristics of an alternative asset class, it shares many similarities with traditional credit strategies. Recent convergence among issuers and investors suggests that direct lending may eventually be viewed as a more mainstream credit option rather than an alternative asset class.

At Lord Abbett, we’ve been in the business of capturing credit risk premiums through diligent research and flexible allocations for decades. Today we see the growth of direct lending creating an attractive and healthy ecosystem for borrowers, asset managers, and end investors. For corporate borrowers, private credit has expanded and enhanced financing options. For asset managers, this space has grown to become an opportunity for flexible and well-resourced credit managers to find value across markets. And for end investors, the performance profile of direct lending offers the appeal of attractive income with a risk-reward profile that can potentially be both a great diversifier to traditional assets and a volatility dampener in asset allocations.

What is perhaps equally as interesting to those looking at this relatively newer investment option is that while private credit overall has some of the hallmarks of an alternative asset class—liquidity profile, product structures, private sourcing—it could be argued that there is more that ties it to traditional credit strategies than not. At its core, it’s about lenders and borrowers, and we can imagine at some point, direct lending may not even be considered an alternative asset class. In the following pages, we discuss the growth of the direct lending market, its effect on, and convergence with, publicly traded credit, and our expectations for the credit environment going forward.

The Growth of Private Credit

Although direct corporate lending has been a longstanding practice, a window of opportunity opened over the last 15 years as the financial constraints imposed on banks after the great financial crisis (GFC) led to a significant shortage of capital for middle-market companies. This regulatory shift led to a massive expansion in the role of direct lending to these businesses. Large private investment houses responded to the increased demand by raising this needed capital through vehicles such as public and private business development companies (BDCs) to allow investors to integrate direct lending into broader diversified portfolios. At the same time, the industry built out human capital to increase the sourcing, assessment, and management of direct lending portfolios to allow for greater loan diversity and transparency, while further increasing investor comfort with the asset class.

Subsequent to the expansion in private credit following the GFC, the aftermath of the COVID-19 crisis served as another major catalyst for both supply and demand in middle market direct lending as well as the larger private credit universe. Figure 1 shows the sharp increase in direct lending’s presence relative to U.S. high yield and bank loans, also known as leveraged loans, around this time and then the strong growth since. Banks pulled back from lending with the uncertainty surrounding COVID-19 and then again after Silicon Valley Bank’s failure highlighted more balance-sheet concerns. Public market volatility also created a good deal of uncertainty around syndicated credit transaction levels and timelines. Having put the pieces in place around fund structures, talent, and adoption, the direct lending community was able to respond quickly to this demand boost. Multi-billion-dollar direct lending funds had the ability to underwrite large deals with certain and immediate terms, leading to increasing regularity of $1 billion+ transactions in the direct lending market, as shown in Figure 2. More supply is expected as the rate shock in 2022 and 2023 has investors shifting toward diversifiers outside of traditional fixed income, and direct lending increasingly fits the bill with its floating-rate loans and low volatility.

Convergence of Private and Public Credit

The demand pull for direct lending continues to develop even in more normal markets. While smaller private borrowers have usually transitioned to public credit markets once their borrowing needs became large enough to warrant public issuance, after they arrived in public markets, they typically stayed there, absent some negative development in the business. While the numbers are modest today, a growing number of borrowers are toggling between public and private markets and in some cases tapping both markets at the same time or even as part of the same issuance.

We expect this trend to continue, as borrowers will always look for the best combination of terms and cost in their capital structure, and private markets have developed into a competitive value proposition for those borrowers. We believe it is critical for investors to do the same kind of value shopping. In that regard, private credit has historically provided an attractive risk and return profile that can potentially enhance an overall credit allocation (see Figure 4).

Private credit spreads have also historically provided an attractive yield relative to BSLs, shown in Figure 5, while volatility has been low primarily because of the absence of mark-to-market accounting. But it is important to remember that much of the public market volatility is driven by liquidity provisioning because the vehicles that hold public credits are often daily liquid vehicles. So, rather than thinking about private credit volatility as understated, it is just as valid to think about public credit volatility as overstated relative to variation in estimated losses from default. Simply put, private structures are purpose-built for spread capture, allowing a manager to focus on the merits of a credit rather than liquidity provisioning.

Historically, then, direct lending has been a solid deal for investors, and we believe the value proposition is intact today. Compared to publicly traded syndicated bank loans, direct lending spreads have generally been above public market equivalents.

We believe the time is fast approaching when direct lending will be viewed not as an “alternative,” but rather a critical piece of market and company risk. Even stand-alone public debt strategies will be made better by the integration of private debt skilled professionals into their teams, and private debt teams will benefit from the insight and reach of their public debt focused colleagues, in our view. At Lord Abbett, we’ve used multi-sector capabilities for decades in our efforts to achieve attractive risk-adjusted outcomes, while managing risk and liquidity, and we believe the best opportunities going forward will be available to creditors and investors who are able to navigate between private and public markets.