Not All Private Credit Is Created Equal

Since the global financial crisis, assets in private credit have grown exponentially as investors search for yield while protecting against inflation and rising interest rates. Once a small corner of the investment universe, private credit has boomed into a major asset class that does not appear to show signs of slowing. Over the 2010-2020 period, assets have exhibited a 12.8% compounded annual growth rate.[1] However, not all private credit is created equal. We believe the private credit landscape is quite diverse relative to its publicly traded counterpart, and investors should take time to fully understand the differences within the space.

[1] Sources: S&P/LCD. Treeline Capital Partners: “Private Credit: An Allocation Strategy for the Next Decade.”

Ways to Categorize Private Credit

Investors have a multitude of ways to categorize corporate private credit utilizing common terms familiar to public investors—sector, borrower credit quality, duration, etc. However, at AFA, we believe that this type of categorization is only one level of diversification within private credit. We believe an important distinction in corporate private credit is the lending type: Asset-Based or Cash Flow–Based. In our opinion, this comparison provides a better framework for evaluating diversification within the asset class because the stark differences in underwriting and servicing between the two lead to different outcomes on the downside.

Cash flow lending (CFL) uses a borrower’s enterprise value as collateral and their cash flow to determine the loan amount and terms. These loans may or may not have covenants, which protect the lender to minimize losses when the borrower undergoes stress. Generally, though, in the case of a default, the lender must work with the borrower to recoup as much of the value of the company as possible, typically through long and complex bankruptcy proceedings.

Asset-based lending (ABL) uses specific borrower assets as collateral, such as property, inventory, and equipment, and the loan amount and terms are based on the value of that collateral. The lender will value the asset on a standalone basis and then advance a loan in an amount less than that value. These loans have covenants that give lenders the right to assume ownership of the collateral in the case of a default, drastically reducing the timeframe and uncertainty around recoveries.