The following article, from an offshore law firm, looks at the rise of private credit, how it works, its place in wealth management, and more.

The following article comes from Michelle Frett-Mathavious, partner in the BVI office of offshore law firm Harneys. She talks about the world of private credit, which has expanded rapidly in recent years, fuelled to some degree β€“ until two years ago – by more than a decade of ultra-low interest rates and tighter capital regulations on traditional banks after the 2008 market crash. 

The rise in interest rates since the pandemic has shifted the equation. The International Monetary Fund recently raised a red flag about potential systemic risks in the growth of such β€œshadow banking.” Even so, the editorial team continues to be regularly regaled about the benefits of private credit and why wealth managers should use it for clients. We will cover this market with a balanced view, mindful of how the long-standing financial trends can be repackaged in new guises. 

The editors are pleased to share this content; the usual editorial disclaimers apply. Email tom.burroughes@wealthbriefing.com if you wish to respond.

The rise of private credit
Global events of the past decade in particular have done nothing if not reinforce the notion of change as the one constant. One area in which the adage certainly resonates is within the global finance system which has itself borne witness to a changing landscape, characterised in many ways by what appears to be a supplanting of the dominance of traditional bank lending with various alternative lending strategies deployed by private credit lenders. 

The vacuum created by the largely retrenched position of banks has opened wide the door for alternative sources of financing for borrowers. As private credit (or private debt as it is also known) continues to amass more and more of the market share previously enjoyed by traditional bank lending, it seems certain that the somewhat subtle shift in the lending market is here to stay.

What could well have been little more than lightning in a bottle, has planted roots and some may say, grown wings since its emergence. The gradual but steady rise in alternative credit originated more than a decade ago as a direct result of what is now commonly known to most as the global financial crisis. Resulting from the meltdown across the global financial system which occurred in 2007/2008 was the creation of certain market conditions and investor demand for alternative sources of credit to plug a gap left by the traditional banking system. Tough conditions often act as catalysts for change and the prevailing conditions at the time ultimately gave life to the alternative lending sources that we see at play within the finance system today.

The market has grown to a position where at the beginning of 2023, it was valued at approximately $1.4 trillion, with an estimated growth trajectory of $2.8 trillion by 2027. By any measure, this signifies the importance of private credit to global finance and lenders operating within the space, who span the gamut from private equity to varying types of funds and institutional investors such as hedge funds. Alternative investment funds have significant sums of money at their disposal for lending. 

This makes the market an undeniably important source of financing for corporates seeking capital and as a counterpoint to the borrower perspective is that of the lenders within the space. The market operates to serve dual interests and as an investment strategy, engaging in private lending has proven very lucrative for the investment portfolios of many private lenders. As long as this continues to be the case, the greater the likelihood that the alternative sources of funding associated with private credit will continue to command the market share it has carved out for itself.

The impact of private credit
The impact of the more recent global events relating to the Covid-19 pandemic, elevated inflation and ongoing regulatory pressures for banks (particularly regarding issues such as regulatory capital requirements for banks) has stifled bank lending over recent years. While the worst of the pandemic now appears to be in the rearview mirror and some indicators point to an ease in interest rates on the horizon in the not too distant future, the regulatory pressures seem less likely to abate. On a macro level this means that we are likely to see a favourable environment continuing for private credit transactions which has developed over the past several years.

It is difficult to deny the appeal of the flexibility associated with private lending. The availability of tailored lending solutions means that, unlike traditional bank lending (which in many ways remains locked into operational practices which can be viewed as cumbersome), private credit lenders have the flexibility to offer borrowers customised solutions for facility size, the form of financing and even timing for completing transactions, all taking into account the specific needs of borrowers. Many private credit transactions also feature floating rates which adjust as interest rates change. The innate flexibility of this approach is one which many borrowers find appealing (particularly when compared with alternate fundraising sources such as fixed-rate bonds). 

While in more recent times it has become clear that private credit transactions involving larger corporates are also on the increase, primarily small and medium-sized businesses (arguably the backbone of most economies) in need of capital for both operational and expansion purposes have benefited most, having found a ready market in private credit. 

Over the last few years, during a period of fiscal stress for many SMEs in particular, the optionality available to them has been a welcome boon. 

Whether the solution for the particular borrower comes in the form of direct lending (which is often made available to private, non-investment-grade companies offering a source of steady income), mezzanine financing or preferred equity (which typically takes the form of junior capital, providing a source of junior debt for borrowers while providing an equity incentive for private lenders) or distressed debt (helping financially distressed companies navigate their way through balance sheet restructuring and operational stabilisation), there is undeniable appeal for borrowers in dealing with lenders with (in stark contrast to traditional bank lending) flexible and innovative approaches to lending.

Navigating the nexus: Private credit and the offshore world
Having established its value to the global credit system, private credit now plays a role in facilitating global capital flows in ways which are both similar and dissimilar to that played by traditional bank lending. 

Increased market share across Europe, the US, Asia and beyond, fuelled by the demand for credit by borrowers and an enhanced investor risk appetite has positioned it to function on a level akin to banks within the context of cross-border financings which typically involve both onshore and offshore elements. 

The same features (such as tax neutrality, efficient regulation and well-established legal jurisprudence) which make the use of offshore vehicles domiciled in jurisdictions such as the British Virgin Islands and Cayman Islands attractive for use in bank financed lending transactions hold true for non-bank financing. 

The flexibility associated with private credit transactions marries well with the flexible nature of offshore corporate vehicles which feature in many cross-border finance transactions. As the market continues to grow and evolve and parties continue to explore ever more innovative financing options, we would expect the commonalities between the world of private credit and that of offshore to continue generating synergies between the two.