Private Credit Funds - Into the Mainstream

What is Private Credit?

Private credit (also known as private debt) is the provision of debt finance to companies by private markets. Private credit funds can adopt several different strategies, but direct lending is the primary one, where non-bank lenders provide credit to companies usually in the form of senior secured debt with a floating rate coupon over the relevant base rate.

According to PitchBook, direct lending accounts for 31.8% of all private credit capital raised through funds. Other private credit strategies include mezzanine (junior) debt, distressed debt, special opportunities, venture debt, private debt fund of funds, and secondaries.

The growth of private credit

The rise of the global private debt market has been truly remarkable – growing from a modest $300bn in 2010 to circa $1.6trillion in December 2023 and, according to Preqin forecasts, the private debt market is predicted to reach $2.8 trillion by 2028.

Meanwhile, direct lending is forecasted to remain the largest private debt strategy and is predicted to increase from 46% to 52% of the private debt market in 2028.

Europe’s share of the global private debt market has grown from a modest 14% ($43bn) in 2010 to 27% ($400bn) in 2022 and forecast to increase to 31% ($860bn) by 2028.

Ireland has been an active participant in this important asset class, and according to Monterey Insight, AUM of private debt assets in Irish funds has grown from $28bn in 2020 to $169bn in 2023.

What are the key drivers for growth in private credit?

Undoubtedly, the catalyst was the 2008 Global Financial Crisis. The (remaining) banks significantly retrenched from the market, leaving a gap which was filled by private credit managers.

Lack of competition from banks provided the opportunity for private credit managers to generate superior risk adjusted returns, and this, coupled with robust due diligence/underwriting, underpinned the success and growth of the non-bank lender sector.

Whilst family offices were the first investors to move into the strategy, over time institutional investors have become very comfortable with this asset class. Today, insurance companies, pension funds and sovereign wealth funds account for over 70% of capital commitments to European non-bank lenders.  

The exponential growth in private credit funds in recent years has therefore taken it out from the shadows and into the mainstream.

Why do investors like this asset class?

• Stability of returns – less volatile than traditional equity or fixed income strategies

• Reliable income streams – steady cashflow from loan repayments

• Natural hedge against inflation – typically floating rate loan exposures

• Attractive risk-adjusted returns

• Lower risk than private equity, as debt ranks senior to equity in the capital stack

• Portfolio diversification, and

• Potential to buy “secondaries” (debt originated by a bank 3d party lender) at a discount

Private credit funds - at the heart of CMU

The capital markets union (CMU) is the EU’s public policy initiative to create a genuine single market for capital across the EU. It aims to get investment and savings flowing across all member states for the benefit of citizens, businesses and investors alike.

A key objective of the CMU is to create an effective integrated European capital market with a harmonised set of rules for loan origination through investment funds, as this is deemed critical to provide European companies with better access to diversified financing options beyond traditional bank lending.

This places private credit at the heart of CMU, and key initiatives including ELTIF 2.0 and harmonisation of loan origination rules under AIFMD 2.0 are key enablers for this asset class.

What’s happening in some of the key private debt/credit segments?

• The mid-market (typically companies with revenues of €10m-€500m) segment has become less crowded in recent times - many of the well-established private credit managers have raised “jumbo funds” with multi-billion capital commitments and have therefore shifted focus to larger ticket deals in the upper mid-market/large cap space.

• Established SME platform lenders (i.e. FinTechs) have moved away from peer-to-peer financing models and are now typically financed through forward flow arrangements with a diverse pool of institutional investors, including credit funds, insurance companies, pension funds, and investment banks. Many of these FinTechs use warehouse/securitisation vehicles and/or dedicated private credit funds.

• Special opportunities and distressed debt funds have raised significant amounts of dry powder, but deployment opportunities have been modest, as defaults remain surprisingly subdued (despite Covid, surging energy costs, rampant input inflation, and spike in interest rates).

• Real estate lending is mixed – funds with office concentrations are facing challenges, whereas residential and logistics-focussed lending funds are doing better.

• European institutional investors are focussed on Article 8/9 Funds but complying with SFDR requirements for Article 8/9 Funds can be challenging - ESG ratings agencies typically don’t rate private companies so private credit fund managers must obtain the requisite ESG data from their borrowers. The good news for private credit managers is that there are several outsourced providers who can manage the end-to-end ESG process, allowing managers to focus on credit origination and management

• Opportunities in the secondary market have increased as investors rebalance their portfolios

• Demand for open-ended structures in private credit funds is increasing. The resultant liquidity mismatch of these funds (which hold illiquid loans with typical maturities of up to 7 years) needs to be carefully managed through appropriate liquidity management tools (ELTIF 2.0 and AIFMD 2.0 make such provisions)

• Increased investor concentration – the ten largest private debt funds account for >50% of capital raised in 2023, up from 35% in 2022.  This appears to be at the expense of first-time managers, whose share of capital raise fell from 24% to 9% in the same period.

European direct lending funds - regulatory challenges and opportunities

Europe remains a regulatory patchwork quilt, with different rules for non-bank lenders in individual EU member states. Such barriers hinder the cross-border flow of capital within the EU.

EU actions to address this include a reboot of ELTIF and an overhaul of AIFMD, which will harmonise loan origination fund rules across the EU by 2026.

Regulatory concerns on the impact of this sector are clearly legitimate. Whilst the debate continues whether non-bank lending exacerbates pro-cyclicity or acts as a buffer to the cyclical stop-start nature of bank lending, it appears that increased regulatory reporting requirements for European private credit funds are on the horizon.

Ireland’s position today  

Ireland is a global centre of excellence for SPVs and securitisation vehicles (e.g. 50% of the global commercial airline fleet is financed out of Irish SPVs) and as at end Q3 2023 Irish SPV’s held assets of €1.1trillion,  predominantly comprising debt securities, loan claims and securitised loans.

Irish regulated funds can invest in any form of credit without any regulatory leverage or concentration restrictions but can’t originate loans. However, Irish regulated funds specifically authorised as a Loan Origination QIAIF (L-QIAIF) can engage in loan origination. L-QIAIF’s must be closed-ended funds, can only invest in credit related assets (but may hold equity instruments issued by borrowers) and are subject to several regulatory restrictions.

The L-QIAIF has been successfully used by managers to lend across the U.S. (as an alternative to the U.S.’s “season & sell” model) and Europe in particular. However, many non-bank lenders use Luxembourg’s RAIF, which is an un-authorised AIF, with no specific loan origination rules. The status quo is set to change by April 2026 as the Lux RAIF and the Irish L-QIAIF will both be subject to same harmonised set of loan origination rules.

Key opportunity for the Irish fund industry

Direct lenders seeking to use Irish fund vehicles can now establish their fund as wither an ELTIF 2.0 or a L-QIAIF, with the rules for the latter set to be relaxed by April 2026, when a single set of rules will apply to managers of direct lending funds across Europe.

These harmonised rules will be less restrictive than the current L-QIAIF regime, so private credit managers considering establishing a new European direct lending fund should carefully consider all the variables when choosing their fund domicile, as their new fund, regardless of its EU domicile, will be subject to the new AIFMD 2.0 harmonised rules during its lifecycle.

This presents a significant opportunity for the Irish funds industry to further scale up its exposure private credit, and direct lending funds in particular.

As a leading European centre for investment funds, Ireland has an extensive ecosystem of experienced fund service providers, with strong expertise in credit as underpinned by the €169bn of credit AUM in Irish funds, whilst Irish fund administrators also administer a significant amount of non-EU AIFs, including Cayman domiciled credit funds.

As a global leader in the SPV/securitisation market, and with the ongoing consolidation in the Irish banking market, there is a latent pool of readily transferrable talent that can be drawn upon by the Irish funds industry, thus underpinning Ireland’s capacity to manage and administer the expected growth in direct lending funds into the future.