“Build it and they will come”: The private credit field of dreams

You will hopefully forgive the title’s intentional misquote. When investors think of private credit, they often think of established sectors such as corporate lending, commercial real estate debt or infrastructure financing. Yet one of the defining characteristics of private markets is not the ability to finance mature sectors; it’s the ability to create entirely new ones.

Throughout the history of capital markets, innovation has often originated from private markets, where flexibility, bespoke structuring and close engagement between borrowers and lenders allow financing solutions to develop before eventually becoming institutionalised. 

Private markets are, at least in my view, the research and development laboratory of the broader financial system.

The evolution of infrastructure debt provides a compelling example. While infrastructure assets have existed for decades, the modern institutional infrastructure debt market is comparatively young. Prior to the Global Financial Crisis, much long-term infrastructure financing was dominated by banks. As regulatory changes constrained bank balance sheets and institutional investors sought long-duration, hard assets and regulated cash flows, private markets stepped in. Today, we continue to see evolution because of the need to continually build assets to address societal and economic needs at a moment when governments have become more funding constrained. 

What followed was not simply growth in issuance. It was the creation of an institutional asset class. Investors developed underwriting frameworks, rating methodologies, covenant structures and portfolio construction techniques. Over time, infrastructure debt evolved from a niche segment to a core allocation for many insurers and pension funds. 

The lesson is an important one. Markets develop because investors are willing to support them before they become established. 

Strong Foundations: The importance of underwriting

New sectors don’t become successful because they are fashionable; they become successful because investors are able to separate durable opportunities from temporary enthusiasm. This is where underwriting matters.

Successful private market investors, in our view, may typically employ a consistent framework regardless of whether they’re assessing a traditional corporate borrower, a renewable energy platform, a fund financing transaction, a property-backed real estate borrower, or an asset-backed financing opportunity.

For us, the questions remain remarkably similar:

• Is there genuine end-user demand?
• What competitive advantage does the borrower possess?
• Is the economic model resilient across different market environments?
• How does the transaction compare with alternative investment opportunities? (namely, public bonds with similar credit and structural characteristics)
• Does the structure appropriately protect downside scenarios?
• Is the pricing sufficient for the risks being assumed?

While the sectors evolve, the underwriting disciplines should not. Indeed, one of the benefits of private markets is the ability to apply established credit principles to entirely new opportunity sets. Investors are not required to wait for an index to emerge or for public markets to recognise a sector. They can evaluate a business, cashflow stream or asset pool based on its fundamentals.

In this sense, innovation in private markets is often less about taking new risks and more about applying proven risk analysis to new circumstances.

Niche opportunities

Many of today's fastest-growing areas of private credit are following a familiar pattern.

Fund financing, net-asset-value (NAV) lending and other solutions serving the private equity ecosystem were once highly specialised activities, conducted by a relatively small number of market participants. As private capital grew, so did demand for financing solutions that extended beyond traditional subscription facilities.

Similarly, emerging market private credit evolved as investors became increasingly comfortable underwriting businesses and projects in jurisdictions outside traditional developed economies. Improved governance frameworks, enhanced data availability and greater institutional expertise have, in our view, broadened the investable universe significantly. Also supportive has been the provision of highly rated support from the likes of multi-lateral development banks, quasi-sovereign and even sovereign institutions. 

The same phenomenon can be observed in parts of the structured finance market.

Many of the underlying activities themselves are hardly new. Equipment finance, transportation assets, consumer receivables and supply-chain financing have existed for decades. Historically, however, they were often analysed in isolation by separate specialist teams within financial institutions. Today, investors increasingly view these opportunities through a more unified lens.

Case in point: Asset-based finance

Asset-based finance (ABF) provides an interesting case study of how private markets continue to evolve.

In the truest respect, ABF is not a genuinely new asset class – and it certainly is not one that is consistently defined! Rather, it represents an amalgamation of a variety of financing activities linked by a common characteristic: assets and cashflows serve as the primary driver of credit quality. 

A combination of bank retrenchment has created the room for continued growth of institutional involvement and innovation across commercial finance, consumer finance, fund financing, esoteric/specialised lending and hard asset-backed lending. However, while these share many legal and structuring characteristics, within each area are a myriad of individual asset classes with specific credit characteristics. This, like any credit investment, requires a nuanced and seasoned understanding to separate the strong from the weak, and avoid the adverse selection that can accompany a late entry into any market.

ABF is a significant form of investment opportunity, encompassing a wide range of more niche asset-supported financing opportunities, and it’s not new; we estimate AUM in the multiple tens of trillions of dollars equivalent. The key point is that institutional investors are increasingly recognising common underwriting characteristics across previously separate markets. This is leading to increasing inclusion in portfolios. 

As institutional capital becomes more comfortable with these structures, market definitions are beginning to converge.

The future: Disciplined innovation

Private debt investing will continue to evolve. Financing solutions, capital structures and borrower types will emerge as economies change and needs become more complex. Yet, history suggests that successful investors may not be those who simply chase whatever is new. They will be those who combine curiosity with discipline.

The ability to understand fundamentals, assess demand, analyse competitive dynamics, compare relative value opportunities and structure transactions appropriately remains, in our view, the cornerstone of successful investing. These principles helped build infrastructure debt into a mature institutional asset class. They continue to underpin growth in fund financing, emerging markets and asset-backed finance today. 

In short, markets change. Underwriting does not. And that may be the greatest strength of private markets: their ability to support innovation while remaining firmly anchored in fundamental credit analysis.

Private markets do not merely allocate capital to emerging asset classes. They play a critical role in creating them. 

 

Assumptions, opinions and estimates are provided for illustrative purposes only. There is no guarantee that any forecast will come to pass. Past performance is not a guide to the future.