24 Mar Private Credit’s Future Based on its History Since the 1980s
By Michael McAdams, President, Pasadena Private Lending
The experienced management team at Pasadena Private Lending has been in unique positions throughout their careers to witness turning points in American debt capital markets. We believe we have paid particular attention to the developments of the past decade, as private credit has expanded and redefined the relationships between business borrowers and their corporate lenders. Furthermore, we see the future of private credit being shaped by the groundbreaking business and credit strategies of Pasadena Private Lending.
The Evolution of Corporate Lending
Fifty years ago, aside from the bond market – accessible only to the largest companies with long-term credit needs – banks were the primary lenders to corporate America. Large banks made direct loans to many borrowers, while the biggest loans were syndicated among multiple banks to spread risk prudently. Medium-sized borrowers often worked with two or three regional banks based where they had distribution or manufacturing plants. As their credit needs grew, a major bank in New York or Chicago would often be brought in to share the deal. Similarly, smaller community banks with growing borrowers would rely on their “upstream correspondent” banks to take a portion of the loan. Despite competition, occasional poaching of clients, and disputes over ancillary banking business, the system functioned well, and banks that played by the rules thrived.
The Birth of Leveraged Finance
The dawn of leveraged finance in the mid-1980s, pioneered by Drexel Burnham Lambert and later expanded by major investment banks, forced traditional lenders to reconsider their loan exposures. When top-tier borrowers became leveraged buyout (LBO) targets, their credit ratings plummeted from “Single A” to non-investment grade, making it imprudent for banks to hold as much of their debt. Among the most notable LBOs were those of RJR Nabisco and Safeway Stores, which transformed from traditional corporate borrowers financed by a handful of banks into entities requiring over 100 institutions to fund their buyouts.
Despite the profitability of leveraged finance, banks began scrutinizing their exposure – not just to individual borrowers but to leveraged borrowers as a whole. At the same time, demand for credit was surging due to the proliferation of private equity firms backed by pension funds seeking extraordinary equity returns, following the lead of pioneers like Kohlberg Kravis Roberts, Forstmann Little, Investcorp, and Hellman & Friedman.
The Market Responds: First Wave of New Lenders
Two major forces responded to this increased demand for lending capacity – one that remained a long-term player and one that did not.
- Foreign Banks: Historically, foreign banks struggled to establish relationships with U.S. borrowers. However, they were now being invited into credit deals despite having no prior trade finance ties or foreign exchange advantages. Both Iain Whyte (Founder, PPL) and I helped our French and French Canadian employers dramatically expand their loan portfolios during this period, cementing foreign banks as significant players in what became known as the Broadly Syndicated Loan (BSL) market.
- Savings and Loans (S&Ls): In the late 1980s, S&Ls received expanded lending authorities to compete with commercial banks. However, their lower capital requirements, lack of corporate lending expertise, and exposure to real estate cycles led nearly all of them to exit corporate lending – or go out of business – within a decade. Despite this, for a time, S&Ls played a crucial role in balancing the market by acquiring non-originating bank loans.
The Rise of Non-Bank Lenders
As S&Ls were entering the market, another, more permanent player emerged. While working at a foreign bank, I participated in a loan syndicate financing an insurance and mutual fund company buyout, including the Pilgrim Group. They observed that floating-rate bank loans lacked the rate-induced price volatility of other fixed-income products and, being senior and secured, had lower default risks than high-yield bonds, emerging market bonds, or preferred stocks.
Thus, in 1989, Pilgrim Prime Rate Trust was launched, and I became its founding portfolio manager. The fund reached $1 billion in assets within 18 months and was quickly imitated by Merrill Lynch, Dean Witter, Van Kampen Merritt, and Eaton Vance. Within five years, there were over 10 similar funds; by 2012, there were over 200 funds, managers, and ETFs managing more than $200 billion in non-bank-held BSL assets.
The Institutionalization of Leveraged Loans
As leveraged financing demand grew, non-bank holdings of syndicated loans eventually doubled those of the originating banks. Banks soon recognized the benefits of recycling their capital-making loans, selling them down by 90%, and using the freed-up capital to make new loans, much like the mortgage market.
Yet, the biggest players in fixed-income investing-insurance companies-had yet to fully participate in the leveraged finance space.
Insurers Enter the Market Through CLOs
Insurance companies, due to their high leverage and regulatory constraints, had strict capital limitations on non-investment-grade debt, including senior secured bank loans. However, in the mid-to-late 1990s, Wall Street adapted mortgage securitization techniques for corporate credit, a process in which Pasadena Private Lending Board Member Dr. Arturo Cifuentes played a role during his tenure at Moody’s.
This securitization process – Collateralized Loan Obligations (CLOs) – pooled loans, creating layered securities with different risk levels. This allowed insurers to participate while maintaining investment-grade exposure. I was involved in 14 CLO transactions totaling over $12 billion, including one of the first U.S. CLOs and the second-ever Euro CLO. By 2006, the BSL market exceeded $1 trillion, with foreign banks and mutual funds holding less than a third of the total.
The Birth of the Middle Market
The Global Financial Crisis (GFC) prompted a reassessment of credit exposure. Although BSL loans performed well, issuing companies used their strong performance to negotiate better terms, leading to weaker covenants, lower pricing, and looser underwriting. Default rates and recovery rates worsened, prompting investors to seek better opportunities.
This led to the discovery of the Middle Market, where loans were structured more conservatively and backed by stronger collateral. By 2012-2014, middle-market loans were significantly smaller than BSLs, typically ranging from $100 million to $300 million for companies with $250 million to $500 million in revenue.
Government regulations post-GFC pushed regional banks to reduce their middle-market commitments. In response, non-bank lenders – including former BSL fund managers – stepped in. By 2020, non-bank middle-market lenders had multiplied, with over 30 middle-market CLO managers and 100+ independent finance companies and funds serving the space.
The Next Frontier: The Lower Middle Market
Just as the Middle Market expanded, competition increased, making it harder to find good loans. Default rates and losses began creeping upward. Enter the Lower Middle Market firms with $1–5 million in cash flow and $5–20 million in revenue.
PPL’s Chairman, after a decade in banking, joined Merrill Lynch to focus on lending to business owners, building a $200 million portfolio with only two defaults and no losses over 18 years. This success led to the founding of Pasadena Private Lending in 2018.
Since its inception, PPL has funded 60 business loans across 25 industries, totaling over $300 million, with less than 1% defaults and no losses.
Looking Ahead
Given the historical trend of private credit shifting “down market,” we believe the Lower Middle Market, with its 100,000 borrowers, will be the next major opportunity in fixed-income investing. While the SBA plays a role in this space, its slow speed and rigidity limit its influence.
Unlike larger markets, the Lower Middle Market remains inefficient due to limited public data, making it difficult for large investment banks and Bloomberg-reliant analysts to navigate. This inefficiency presents a unique advantage for experienced specialists like PPL. Plus, while the borrowers may be smaller, the pool of opportunity is much greater and likely to grow significantly in the coming years.
As history has shown, private credit continuously evolves – and PPL is positioned at the forefront of its next transformation. Should you have any questions about this article or how PPL can serve you, please do not hesitate to contact us.