The growing power of private credit direct lending

Business is booming on the buy side for the direct lenders of private capital. But it’s not all bad news for the sell-side banks that have traditionally dominated the commercial lending market.

The rise of direct lending

After a year of record-breaking volumes of direct lending to middle-market firms, private credit looks likely to achieve double-digit growth again in 2024.

Banks, by contrast, are holding back on commercial loans as they weigh up the quality of their portfolios, risky concentrations in commercial real estate and the capital requirements of the Basel III endgame.

With tighter spreads making risk-yield ratios less palatable for banks, buy-side private capital firms have been happy to fill the void left in the loan market – and then some. In fact, the private credit industry has been growing by nearly 25% a year for 20 years.¹

The payoff for banks

When it comes to issuing debt to large corporations and middle-market firms, banks aren’t wholly opposed to private credit’s new leading role – and won’t necessarily compete for the same deals as private capital providers.

Yes, there’s some discomfort in the industry that private capital firms are encroaching on banks’ territory by providing structured finance to corporates. After all, the resulting disintermediation of relationships means banks lose out on fee-based revenue from one of their primary businesses, whether as a lead agent or part of a bilateral arrangement.

But this is no all-out turf war. In fact, something of a symbiotic relationship is emerging between banks and private credit providers – many of which are just as likely to be a bank’s client as its competitor.

Private credit relationships can add value to banks by acting as a relief value for loans they don’t want on their balance sheet – or whose risk-return won’t pass hurdle rates for capital investment.

So, to meet their higher capital requirements and move portfolio risk weights downward, banks are happily entering into more capital relief trades with private credit firms.

Everyone is a winner in this type of transaction. The bank doesn’t have to bear the first loss credit risk and can therefore reduce the deal’s risk weighting and associated capital allocation. And in exchange for the risk on a high-quality asset, the private capital firm earns an unlevered return for its investors.

The operational challenge

The direct lending boom could be the start of a greater convergence between the buy side and the sell side. Equally, it could simply indicate a temporary dislocation of demand from corporate borrowers, which banks don’t have the appetite to fill.

Either way, the current market dynamics present something of an operational liquidity challenge for buy-side participants.

Namely, private credit providers will now need to extend and integrate their asset management, private equity and funding accounting solutions into a wider ecosystem with corporate lending solutions.

FIS® is in a unique position to help. With our best-in-class solutions for fund and loan servicing, which are already serving a broad and deep client base, buy-side firms can quickly take advantage of new market opportunities in commercial lending.

¹Bloomberg Law, The Rise of Private Credit, September 2023