How Has Private Credit Evolved and What Key Structures Define It?

The private credit market has seen extraordinary growth over the past two decades, expanding from $200 billion in 2007 to over $600 billion just ten years later.

This surge is often attributed to the 2008 global financial crisis and subsequent regulatory changes, such as the Dodd-Frank Act in the U.S. and the Basel III framework in Europe. As banks became more regulated and restricted in their lending practices, particularly to small and medium enterprises (SMEs), private credit funds, hedge funds, and private equity stepped in to fill the gap.

This shift has fundamentally transformed the landscape of lending, giving rise to specialized structures, such as fulcrum securities, unitranche loans, and covenant-lite loans, among others.

In this article, we will explore the key concepts and structures within the private credit space, providing insight into how investors and fund managers navigate this increasingly complex market.

Fulcrum Security: A Key Focus in Distressed Debt

In the context of private credit and distressed debt investing, a fulcrum security plays a pivotal role. The fulcrum security is the senior-most debt in a company's capital structure that is not fully repaid in cash during a reorganization process. Instead, it is typically converted into equity in the reorganized firm.

For investors seeking a loan-to-own strategy, targeting the fulcrum security allows them to take a controlling interest in the company post-reorganization by receiving equity instead of cash.

Fulcrum securities are most relevant in distressed situations where a company's assets and cash flows are insufficient to fully repay its debt obligations. Investors in these securities focus more on the value of the underlying assets rather than the company's ability to meet scheduled interest and principal repayments.

This strategy is a hallmark of distressed debt investing, where the endgame is often taking ownership of the company through the reorganization process.

Loan-to-Own Strategy: Seizing Control Through Distressed Debt

A loan-to-own investment strategy is a hallmark of the distressed debt space. Here, the investor provides a loan with the primary objective of taking control of the company's assets or operations in the event of a default or reorganization. Unlike traditional lending, which evaluates a company’s ability to service debt, loan-to-own strategies focus on the potential repossession of assets should the borrower fail to meet their obligations.

Investors following a loan-to-own approach often target companies with valuable assets but financial difficulties. By investing in distressed or fulcrum securities, the lender can gain control of these assets during a bankruptcy or restructuring process. This strategy is common among hedge funds and private credit funds specializing in distressed debt, where the ultimate goal is to unlock value by acquiring ownership of the underlying business.

The Growth of the Private Credit Market

The global financial crisis of 2008 triggered a paradigm shift in how credit markets function, particularly for SMEs. New regulations like the Dodd-Frank Act and Basel III imposed stringent capital requirements and stress tests on banks, forcing them to reassess their lending practices and reduce risk.

This resulted in European banks shedding over EUR 600 billion from their balance sheets and cutting back lending to SMEs for five consecutive years. The reduced availability of bank financing created a void in the market, allowing private credit funds to step in and fill the gap.

As banks pulled back from riskier lending, hedge funds, private equity funds, and private credit funds became key providers of financing, particularly in areas like distressed debt, mezzanine loans, and unitranche structures. Private credit has since emerged as a critical part of the broader financial ecosystem, providing more flexible, tailored financing options that traditional banks no longer offer.

Credit Risk and Credit Spreads: Managing Risk in Private Credit

Private credit investing is inherently tied to credit risk, which refers to the potential failure of a borrower to meet their debt obligations. As a borrower’s credit quality deteriorates, lenders demand a higher credit risk premium to compensate for the increased likelihood of default.

This risk premium is reflected in credit spreads, the difference between the yield on a debt security with credit risk and a risk-free security, such as U.S. Treasury bonds.

All non-Treasury fixed-income products, such as high-yield bonds, bank loans, and corporate bonds, trade at a spread relative to Treasuries. For private credit investors, managing credit risk means carefully assessing the likelihood of default and monitoring the credit spread to ensure they are adequately compensated for the risk.

Covenant Structures: Incurrence, Maintenance, and Covenant-Lite Loans

Covenants are contractual clauses that protect lenders by imposing restrictions or requirements on borrowers. In private credit, covenants are critical tools for managing risk and ensuring the borrower remains financially sound throughout the life of the loan.

1. Incurrence Covenants: These covenants prevent the borrower from taking certain actions once a specified event occurs. For instance, a borrower may be restricted from taking on additional debt or paying dividends after reaching a certain leverage ratio. Incurrence covenants are typically found in more flexible debt agreements.

2. Maintenance Covenants: These are stricter than incurrence covenants and require the borrower to meet specific financial metrics regularly, such as maintaining a certain debt service coverage ratio or leverage ratio. Failure to meet these metrics results in a covenant breach, potentially triggering default.

3. Covenant-Lite Loans: In the private credit market, covenant-lite loans have become increasingly common. These loans place minimal restrictions on the borrower, offering more flexibility. However, they expose the lender to greater risk, as there are fewer financial controls to ensure the borrower’s health.

Unitranche Debt: Simplifying the Capital Structure

A unitranche loan is a single debt instrument that combines senior and junior debt into one package, typically at a blended interest rate. This structure simplifies the borrower’s capital stack by consolidating various layers of debt into a single facility. Unitranche loans are often used in private equity and leveraged buyouts, providing both senior and subordinated financing in one loan agreement.

The key advantage of a unitranche structure is its simplicity for the borrower, who only has to deal with one set of loan terms and one lender or lending syndicate. For lenders, the structure offers a blended return that compensates for the risk of including both senior and junior debt in the same loan.

The Role of DIP Financing in Bankruptcy

During bankruptcy proceedings, debtor-in-possession (DIP) financing is used to provide additional capital to a company while it reorganizes under Chapter 11 bankruptcy protection. DIP financing allows the company to continue operations while working out a plan of reorganization. The lenders providing DIP financing often have super-priority status, meaning they are repaid before other creditors, giving them additional protection.

DIP financing is critical in the restructuring process, as it allows the company to stay afloat while restructuring its debt obligations. For private credit investors, participating in DIP financing can be a high-risk, high-reward opportunity, as it often offers favorable terms and priority repayment.

Conclusion: The Private Credit Landscape and Its Investment Structures

The private credit market continues to expand, offering diverse opportunities for investors willing to navigate the complexities of credit risk, covenant structures, and distressed debt. With banks stepping back from riskier lending, private credit funds have filled the void, providing bespoke solutions such as fulcrum securities, unitranche loans, and loan-to-own strategies. As regulatory changes and market conditions evolve, private credit remains an essential part of the modern financial ecosystem, offering both challenges and opportunities for sophisticated investors.

At Orgon Bank, we offer insights and strategies to help investors understand and navigate the private credit landscape, ensuring that they can take advantage of these structures while effectively managing risk. Whether you're interested in distressed debt, mezzanine financing, or unitranche loans, our team is equipped to guide you through the complexities of this growing market.