A decade ago, private credit barely registered in the public consciousness. Today, the term is on everyone’s lips and every financial institution worth its salt wants to get involved.
Private credit, essentially non-bank lending to private companies, has indeed seen exponential growth since the 2007-8 Global Financial Crisis and the global private credit market today is worth almost $1.7 trillion, according to data provider Pitchbook. This is expected to double in size to $3.5 trillion by 2028.
(As a side note, private credit itself is only a 17% slice of total ‘private market’ assets that also include private equity, real estate and infrastructure.)
There are good reasons for this explosive growth. On the supply side, the traditional banking system has been constrained by regulatory restrictions, higher capital requirements and stakeholder caution, particularly since the financial crisis.
That has created an opportunity for other providers of capital, attracted by good returns from lower volatility instruments that can usually be held to maturity, and are typically floating rate, thus providing interest rate protection.
Meanwhile, borrowers value interacting with sophisticated long-term partners that support them through market cycles and appreciate that deals can be structured flexibly. Additionally, in our experience, private credit direct lending deals are more likely to close and to close more quickly in comparison to traditional loans.
Going direct
As the private credit market has grown and evolved, providers have specialized, focusing on (still sizeable) niches where they can hone their skills and build networks and a track record.
For NXT Capital, a wholly owned part of ORIX USA since 2018, that niche is direct lending and, specifically, direct lending to the lower middle market. In the US, the middle market is the backbone of the economy, comprising some 200,000 companies that contribute a third of the country’s private sector GDP.
NXT Capital supplies capital mainly to those companies that have EBITDA of $5-35 million at the time of the initial deal and that are sponsored (in other words, owned) by a private equity firm, providing them with a dedicated, involved and deep-pocketed backer.
Moreover, NXT Capital provides only first lien senior secured loans, putting it at the top end of the capital structure and all of its loans are floating rate and structured to include at least one financial maintenance covenant.
“We provide investors exposure to private equity-sponsored deals, and our goal is to help them achieve higher returns than equity investors while assuming lesser risk,” says Ted Denniston, Senior Managing Director and Co-Head of NXT Capital.
The advantages of operating in the lower middle market are manifold, he explains. Often, NXT Capital will be the sole lender to the business in question, allowing NXT Capital to conduct extensive due diligence, interact directly with senior management and the private equity sponsor, as well as insist on strict covenants and monthly financial reporting.
Not clubbable
This is very different from the competitive club deals that are typical for larger deals, where agents have exclusive access to the borrower and deal structures are typically covenant-lite with fewer controls and reporting requirements. And a world away from the traditional syndicated loans organized by banks that can involve dozens of investors.
NXT Capital has competitors, of course, but these are a small group of similar specialists rather than the household names of the banking world that are less focused on smaller deals. “We believe NXT Capital has built a strong, defensible position in what is, frankly, the less efficient lower middle market,” adds Joseph Lazewski, Senior Managing Director and Co-Head of NXT Capital with Mr. Denniston.
Lower efficiency, in this case, generally means higher risk-adjusted returns. With interest rates at current levels, Mr. Denniston believes yields can increase, sometimes even more with added leverage. While returns in direct lending are generally lower than the IRRs targeted by private equity or distressed lenders, it can match them on a risk-adjusted basis and puts the returns from a standard bank loan into the shade.
Direct lending as an asset class is attracting investors from pension funds and insurers to endowments, universities, family offices and, increasingly, retail funds bundled by intermediaries. This year, Mr. Denniston and colleagues from ORIX USA’s Asset Management team launched a marketing tour in Japan, supported by ORIX Corporation, NXT Capital’s ultimate parent. During prospective investor meetings they found the asset class is garnering not only widespread interest among institutions, but also interest from brokers who gather retail assets under Japan’s expanded NISA tax free savings scheme.
Building the business
Deploying all that money requires infrastructure and NXT Capital has built a platform that offers single- and multi-investor vehicles, loan funds and separately managed accounts (SMAs). This is backed by over 100 professionals including a senior two-person team focusing on workouts.
While the NXT Capital default rate is very low (<1%), if a default does occur (necessitating a workout), Mr. Denniston, cites NXT Capital’s historic recovery rates of more than 80%, which compare favorably to middle market leverage loan recovery rates of around 58%, per the Cliffwater Recovery Index.
This kind of success over the years since NXT Capital’s founding in 2010 – with Mr. Denniston and Mr. Lazewski as part of the original team– has grown NXT Capital’s assets to $10.1 billion as of September 2024, of which around $2 billion is from ORIX USA’s own balance sheet. In a good year, the firm is able to deploy $3-4 billion of capital.
Will the good times last?
While the US economy has been slowing, neither Mr. Denniston nor Mr. Lazewski foresee a recession. The private credit/direct lending market is less concerned with the absolute level of interest rates given the floating rate nature of its loans.
Meanwhile, the abundant ‘dry powder’ held by private equity firms suggests the volume of mid-market transactions will pick up again after several quiet years. Mr. Lazewski notes that bid/ask prices are coming closer together while Mr. Denniston notes that as US rates fall, higher leverage may return, enabling more deals.
When all is said and done, the growth of private credit is a secular and structural shift and one that may still be only in its infancy.
Caution Concerning Forward Looking Statements:
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