Nathan Hunt
Hi. This is the Seek & Prosper interview series from S&P Global. My name is Nathan Hunt. Today, I'm going to be talking to Ruth Yang, the Global Head of Thought Leadership at S&P Global Ratings, and our topic is going to be private debt. The private debt market has grown tenfold in the past decade, which means that this relatively obscure area of finance is suddenly very much on people's minds. So Ruth, thank you for joining me.

Ruth Yang
Thank you for inviting me, Nathan.

Nathan Hunt
Let's start with the basics because I think I'm going to need the basics here. What is private debt? And how is this different from public credit markets?

Ruth Yang
So private debt is traditionally debt that is raised to fund private companies. However, it does, in today's market, include privately placed debt, which is bank loans or leveraged loans, which do fund public and private companies.

Where the line is really drawn is that the debt itself is private debt. It is not subject to the same transparency and liquidity that public debt is. Public debt belongs to companies that generally file public filings, so you know what their financial conditions are. They are almost always rated. They trade on usually public exchanges. There's a lot more transparency about the health of the companies.

In the private debt world, the issuers are less likely to have public filings. They are less likely to have ratings. So there is a large segment that is rated in the broadly syndicated market. So just the dynamic is very different. But it is a deep and healthy and thriving market. And so I think really where the difference is in the private markets, investors really have to know their credit work. They have to do their credit analysis. They have to understand how credit works. They have to understand the relationship between them and the borrower. It's a -- it's kind of a long-term relationship. It's not a short-term relationship and thus, it is largely an institutional market.

Nathan Hunt
So I know S&P Global Ratings produces ratings for the public markets. How much are you guys rating within the private markets?

Ruth Yang
So as I said, the broadly syndicated market, right, of loans is still technically part of the private debt. It is private debt. It is fundamentally privately placed debt. Within broadly syndicated, we rate about 85% of that market. So we -- it is a largely rated market.

To raise that size of debt, right, these deals range from $1 billion on the very low end to $10 billion or $12 billion, sometimes higher than that, you need to have the transparency of ratings and a lot of other information in order to bring arrangers in the middle with -- bring the correct array of lenders to market and to reduce the cost of capital as much as possible.

So ratings are an important part of the functioning of the very large side of the private debt markets, right? So some of that private debt does not -- the issuers do not necessarily have public filings about their financials. They have -- they sit behind the private wall, but they do have public ratings which helps keep the market moving along.

Nathan Hunt
As I'd said, private debt has expanded greatly in the last 10 years. What's been driving that growth?

Ruth Yang
So there's 2 things, one of which is, of course, everybody wants to make a buck, right? So everybody is looking for a good return on their investment. For private equity firms, right, the investment in the more middle market side of that -- of private debt has been that market has really benefited from private equity looking for a good return opportunity.

So there's a lot of M&A activity that is what we call sponsored or private equity-driven activity. They put a lot of money in. They need to raise capital. The search for yield is kind of the other side of the liquidity equation, which is investors in their search for yield, are willing to participate in these loans, these private debt transactions because the yield on them is better. They are spec-grade transactions largely, so they get a nice yield on them, and that's really been good.

I will also argue that in the last 10 years, when we talk about the middle market direct lending segment of private debt, one of the reasons it has grown so exponentially, quite frankly, over that time period is in the first 10 years of 2000, as I age myself here, the broadly syndicated market really came into its own being. And the broadly syndicated market, I think, demonstrated that private debt could still function as a real capital market, right? It didn't have to be a public market for it to work.

The broadly syndicated market is a very healthy, functioning capital market, but it largely sits in the private world. There's a lot of restrictions about information. There's not a lot of consistent opacity. There's good liquidity. It functions very well. And I think that, that paved the way for these last 10 years when the smaller side of the market, the more traditional middle market, came into fruition. I think that it was -- these investors said, look, we can do our credit homework. We can make this work. We don't need to have full perfect transparency. We do our homework and the market has enough framework for it to function and be healthy and for us to have confidence in it.

Nathan Hunt
Okay. So let's return to the search for yield. The search for yield is meaningful in a 0 interest rate environment. But as the Fed turns more hawkish, will private debt markets continue to flourish from a search for yield?

Ruth Yang
So I think the search for yield is always an important metric, right? Everybody wants to have as much of a yield as possible on their investments. It's very hard to achieve it than opportunities are narrow in a 0 interest rate environment, right?

So will private debt continue to flourish? Yes, I think it will. I mean private debt is largely floating rate. So as the Fed raises its rates, investors, clearly, prefer floating rate over fixed rate. We can see that in the performance of the loan markets versus the bond markets, definitely in the first almost half of this year, I guess, we're at. And definitely since the war in Ukraine has occurred and the capital markets have slowed down, where we've seen activity is really in the loan market, floating rate will dominate for the next year, 1.5 years, I'm guessing, in this rising interest rate environment.

I think the challenge of the rising interest rate environment really is for these direct lending borrowers, they are traditional middle-market companies. They are probably more sensitive to the rising interest rate environment. So the trade-off really is they have -- they will potentially have more struggles as interest rates rise, as they look at their margins, they look at their costs, their customer base. I think that there is more risk there for investors in direct lending, the private lending space with middle-market companies that those -- the performance of those companies is probably going to be more stressed in the coming years.

At the same time, this is a credit market. The investors and the managers in this area, they do their credit homework. They understand the relationship. This is, again, as I've said, this is a long-term relationship for a lot of them, where they know that they are getting in, they aren't going to exit in 3 months. It is a long-term relationship. And so I think that they do their homework and they understand those risks.

Nathan Hunt
So what are the benefits of private debt for lenders and for borrowers?

Ruth Yang
Well, for borrowers, the benefit of private debt really is the efficiency of it. They are able to access capital, raise capital much more quickly than they can in any other traditional way, right? The margins are slightly higher in the direct lending market than there is in broadly syndicated. So you are a larger middle market company and you could choose between direct lending and broadly syndicated.

If you go to the broadly syndicated markets, your margins will probably be narrower because the liquidity, the demand for your paper is strong enough that will compress your margins and you'll pay LIBOR 2.25 maybe. At the same time, if you go in the direct lending market, the process of raising that capital and accessing it is usually much shorter. The asset managers who specialize in middle market lending tend to transact much faster, you'll probably pay another 1 point, 1.5 points, depending on your credit quality, maybe 2 points, it depends. But the process is more efficient.

For lenders to the market, it's really a better deal. You get a little more margin. You get, we hope, better documentation. So a lot of the documentation issues that we've seen in broadly syndicated such as no maintenance covenants, all of this degradation and document quality that we talk about where there's this additional language built in where they can access additional capital, you can get prime, we have all of these phrases for it, the documentation is much tighter in the middle market. And I think more importantly, you have a real relationship with the borrower, where you feel as someone who has lent someone $1 billion that you actually have some say in what goes on with management decisions. You see the financials. You probably have maintenance covenants. You get a little bit spread.

If you are a -- if you are a lender who is in it again for a long-term relationship, the quality of that relationship, the relationship, the strength and your influence over that company is much better in the direct lending market.

Nathan Hunt
I know light covenants or no covenants has been an increasing trend in credit markets. Why is it within private debt that covenants continue to be strong?

Ruth Yang
Well, I think covenants continue to be strong because that is kind of the selling point where in broadly syndicated you are 1 of 10, 20, 100 different lenders, right? You have exit options where there's a secondary market, there's some liquidity there. It's a little bit of a different construct. It is more of a bond approach to investment than it is of the traditional loan approach.

In direct lending, it is -- I think it's important to have a different set of documents and to have those maintenance covenants because you suddenly -- the good news is you have a one-on-one relationship with a borrower, right? You have a closer relationship. You get to know what's going on. The bad news is you're really in it for the long haul, right?

So you want to have those additional protections to know that if something goes wrong, you have a way to keep an eye on the quality of the company that you're investing in, that you have power, you have some influence, that you have a contractual relationship. So I think it's very important to have that as the lender to the deal. And I think for the market to function, quite frankly, it's really important because of the assurance to people coming into this market that those -- that basic framework of a relationship continues to exist.

Nathan Hunt
Okay. So Ruth, what is the character of private debt? Is this just debt for semi-dodgy companies that couldn't cut it the public markets?

Ruth Yang
No, not at all. I mean these are spec-grade instruments. There's no doubt that these are speculative-grade companies, but being -- having spent my life in the spec-grade market, I'm okay with that, right?

They are really middle -- medium-sized company, the traditional middle market. So they are start-up companies. They are companies that are growing. They're in the developing phase of their business cycle, right? They are hoping, 1 day, to be a large corporate. But they are companies that are starting out on their journey, and they are looking for opportunities to raise capital so they can grow and become bigger companies and more established companies.

I think what also is really important is maybe a little history of why middle market and direct lending matters in the U.S. It's important to realize that the growth of the U.S. middle market, direct lending market is really largely tied to the establishment of BDC financing by the U.S. in 1980, I believe.

So what the idea behind BDC funding, which is, so the BDC allows an investor to create a BDC to invest in direct loans and have a lower cost of financing, right, has to have a reserve, how the reserves work. I'm not terribly smart about that. But what I know it does is if you are a BDC, you can invest in middle-market direct loans. Your cost of funding is much lower. It's not the traditional cost. But in return, you have to file quarterly filings so we can see what's in your portfolios.

But the whole idea was to encourage investors to invest in direct loans so that it would grow SMEs, small or medium-sized enterprise companies. So this was, in the altruistic way, an effort to encourage lending to these smaller companies so that we could nurture and grow them that it wasn't just large corporations that were getting capital allocation.

Nathan Hunt
This is interesting. So this is the U.S. example, but what do private debt markets look like in the rest of the world? Are they as strongly developed? Or is this sort of an American phenomenon?

Ruth Yang
No. I mean they're definitely quite healthy. I don't -- so the difference between the U.S. and the European model is 1 fundamental difference is in the U.S., we are allowed to BDC. So retail investors, mom-and-pop on the street, my mom can go and buy shares of a BDC and invest in these direct loans indirectly, right? And to be fair, broadly syndicated loans can also sit in money market funds, prime rate funds so we can buy mutual funds and access these loans, too.

In Europe, there is no retail access to loans in general. But there are institutional investors, family investment groups that buy and invest and participate in the direct lending space. I know quite a few have grown over the last year. There's a lot of interest in the space. Direct lending funding exists in a lot of different formats. In the U.K., there are middle market lenders who arrange these deals and participate in them.

And quite frankly, in France, in Germany, in Italy, the regional banking system fosters the growth of these direct loans, and they do a really good job of it to encourage the growth of companies on the smaller scale. And in the U.S., we also do see regional banks participating quite a bit in this market, supporting it and raising capital on it.

Nathan Hunt
What's the profile of the investor or lender for private debt? Is this some sort of specialty fund? What does that look like?

Ruth Yang
In the U.S., it ranges. I mean, there's private funds that invest in it. There are institutional funds. So you'll see insurance companies, you'll see just separately managed accounts that invest in it. We do have middle market CLOs. So there are CLOs that allow assets within the middle market direct lending space to be part of their collateral. They've grown quite a bit over the last 5 years, in particular. S&P is very good at rating them. So I'll admit that. And then the BDCs really are a big arm, I think, for raising capital in that market and allowing the middle market direct lending market in the U.S. to grow.

In Europe, it's all separately managed accounts. It's all individual investor, individual institutional investor money. But there is a lot of interest in it. Particularly now, this search for yield that has existed for quite a while for the last couple of years, it's become particularly acute with around the world, we see very low interest rates. We see a lot of institutional money coming in into the direct lending space because it's just 1 more area where they can pick up yield.

Nathan Hunt
How much are regulators involved in private debt markets?

Ruth Yang
Not very much. So I think that they are considered private debt. And probably until something goes a little pear-shaped, that will be true. But the BDC managers have oversight, right? They are subject to regulation and requirements. We rate them as a rating agency. The individual investments, the individual direct loans are not really subject to any specific regulatory requirements. It really remains to be seen whether that changes in the coming years.

Nathan Hunt
So Ruth, 1 final question. What is 1 crucial thing that market participants should know about private debt markets that they don't know right now?

Ruth Yang
I don't know that I know things they don't know. But I think the thing that I'd like them -- everybody to remember is we, in Ratings, know that this is a challenging time. This is a time of significant change. We have rising interest rates. We have record-setting inflation, right? We have all of this disruption from a war that was -- we did not begin this year thinking would be on our plate, right?

As a result, we have the continued disruption of supply chain. We're facing a lot of concerns about growing -- growing concerns about food shortages. This is a very different world today than where we started the world at the beginning of the year.

That being said, the markets are shifting. We've seen that the bond market has largely shut down. The loan market has slowed quite a bit. And we've seen this rising interest in direct lending. We've seen a lot of -- we've seen a fair number of deals move from broadly syndicated into the direct market.

And it can go 2 ways, one of which is there are some school of thought that says, well, this is just people trying to avoid scrutiny and to go to a market where there is less transparency. And I'm not saying that everybody -- that isn't true at all. But I would say the other thing that I would remind people, and I've been reminding people is that, the benefit of the direct lending market right now is that it gives a chance for investors and arrangers and borrowers to figure out what the right terms, what the right pricing is for the deals that are done, right?

It allows every -- it's kind of a discovery period where people can sit down, and in the best case scenario, figure out how to keep the credit markets open and then to give borrowers a choice on how they wish to proceed. Smaller borrowers will remain in direct lending, and I think that they need that. I mean, I think that this is a tool to keep things moving along in the economy.

If we relied fully on the public markets, it would really be hard, I think, to get deals done. And we need to have companies continue to fund their activity. We need to have buyouts. We need to have all of the normal activity of a healthy economy. And these companies need to have the capital investment.

So while the world may feel like it's going very, very pear-shaped, right, the move to these -- into private debt isn't, for me, necessarily a bad sign. I think it's a way for us to figure out what is the right way to move forward and then to make sure that capital can keep flowing into these companies and into these markets so that we don't just end up freezing up and shutting down, which is really the worst outcome we can imagine.

Nathan Hunt
So I think we'll have to leave it there for today. Ruth, thank you so much for talking to me.

Ruth Yang
Thank you, Nathan. Thank you for inviting me.

Nathan Hunt
And thanks to all of you for joining us for this Seek & Prosper interview series.