Covenant Lite #1: A History of Private Credit
Forces that shaped the industry and where it's going
Private credit is annoyingly popular these days. From newspaper articles to Instagram memes, it is seemingly everywhere. Some are even calling it the “Golden Age” or “Golden Moment” of private credit. But why has something as boring as lending money, formerly the domain of dusty old banks, somehow become new and hip and trendy? In this post, I’ll break down the history of what has quickly become one of the most important asset classes in finance.
A bit about me: I work at a large asset manager in New York City where I focus on investing in private credit funds from talented emerging managers. I’ve led a number of multi-hundred million dollar fundings in (mostly) niche areas of private credit like music royalties, trade finance, venture lending, tax credits and other areas. I find the asset class fascinating in its breadth and want to use this substack to teach others as well as to further my learning through writing. I aim to write 1 post per week on a variety of topics related to private credit.
Let’s jump into it.
“Usury is…said to be the price of tyme, or of the delaying or forbearance of money”
-Francis Bacon
The Origins of Private Credit
The practice of lending money is old. Like really old. Scholars say it dates back to ancient Mesopotamia, around 3,000 BCE, where the earliest records of loans were found scratched onto clay tablets. Temples and palaces functioned as early “banks” where farmers and merchants could borrow grain or other forms of money.
As society advanced, bankers became a powerful force in their communities. Prominent banking houses such as the Medicis and the Rothschilds grew to positions of prominence, funding everything from wars to artistic movements.
Over time, capital markets developed in more advanced economies and chipped away at the dominance of banks. Capital markets offered the ability to finance activities through public bond or equity issuances instead of (or in addition to) bank loans. But it was generally only larger, investment-grade companies that could tap capital markets for financing. Small- and medium-sized businesses (the so-called “middle market”) were still primarily serviced by regional and community banks.
For many middle market businesses, the model worked fine (for the most part). These businesses were able to get loans at fair interest rates in a reasonable amount of time from their local banker. The loans were secured by a first lien on all of their assets, which enabled lenders to recover the majority of their principal if the company went bankrupt.
But the relationship between middle market companies and their regional bank partners was not without its limitations. Periodic banking crises brought increasing layers of regulation to banks that restricted their lending activities. Banks tightened their underwriting criteria to minimize losses. Loan documents became increasingly boilerplate rather than tailored to the nuances of the underlying borrower. This was not ideal for middle market borrowers, but they had few alternatives.
Some specialized non-bank lenders and insurance companies began exploring middle market loans in the 1970s, offering more flexibility than banks, but these firms were rare. Things began to change in the 80s, however. There was a man by the name of Michael Milken working out of an upstart investment bank in California who was pioneering the world of high-yield bonds - and whose work hinted at new opportunities for middle market financing more broadly.
The Inflection Point: 1980s and Michael Milken
Michael Milken’s role in the story of private credit is not to be understated. He is a central character in this story—and likely more responsible than any single individual in the formation of private credit.
Milken entered the financial world in 1969, joining Drexel Harriman Ripley, which later became Drexel Burnham Lambert. At Drexel, he quickly realized that Wall Street was focused almost exclusively on large, established corporations with top credit ratings.
Smaller companies without pristine ratings were largely locked out of capital markets, forced to rely on bank loans from regional or community banks—or to struggle for growth without any external funding at all. To Milken, this presented an enormous untapped opportunity.
He began to develop a theory that high-yield bonds could be used as a tool to fund smaller companies, those undergoing turnarounds, or even ambitious startups. He believed that if priced correctly, these “junk” bonds weren’t junk at all—they were an overlooked asset class that could help companies grow and thrive.
He convinced Drexel to let him start a high-yield bond department in Los Angeles, far from Wall Street, where he could work without the constant criticism of traditional bankers who were used to the status quo. From his office in LA, he transformed Drexel into a powerhouse in high-yield debt issuance. He went directly to companies with his pitch, helping them understand how issuing high-yield bonds could allow them to expand and innovate. Before long, companies were coming to him.
As an investment bank, Drexel had limited capital to lend out and so Milken had to create a market of willing buyers for his high-yield bonds. This involved educating potential investors on the benefits of investing in something previously considered “junk”.
He used extensive historical analysis to demonstrate that a diversified portfolio of high-yield bonds could offer attractive returns with manageable default risk. Over time, he built a reputation for generating strong returns and successfully managing risk in the space, which helped instill confidence in his early backers and convince new converts.
He was helped in his efforts by the deregulation wave of the 70s and 80s, which enabled mutual funds, insurance companies and pension funds to more easily invest in lower-rated securities. And invest they did. In the late 1970s, the high yield bond market had less than $10bn in outstanding debt. By the late 1980s, largely due to Milken and Drexel Burnham Lambert, the market had grown to over $200 billion - an exponential increase in a decade.
High yield bonds became a critical tool for corporate financing, particularly for leveraged buyouts (LBOs) as practiced by corporate raiders like Carl Icahn, T. Boone Pickens and Nelson Peltz.
By the mid-1980s, Milken was one of the most powerful figures in finance, earning more than $500 million in a single year. But his aggressive tactics would eventually lead to his downfall. Regulators took notice, and in 1989, Milken was charged with securities fraud. He pled guilty to several charges and served two years in prison, but his legacy in the high-yield market remained. Institutional capital was now willing and able to finance middle market companies. In many ways, private credit as we now know it is the modern extrapolation of what Milken pioneered in the 80s: a way for companies that are “unbankable” to access capital in an efficient manner.
Regulation Makes its Presence Felt
Another important character in the story of private credit also made its first appearance in the 1980s: The Basel Accords. While less colorful than Michael Milken, the Basel Accords were no less impactful on the ultimate trajectory of private credit.
The first of the Basel Accords, Basel I, was introduced in 1988 with the goal of creating a global banking standard in the aftermath of the Latin American debt crisis of the 1980s - and amidst fears that Japanese banks in particular had an unfair advantage over other banks given their low capital requirements. Basel I introduced the concepts of risk-weighted assets (RWA) with simple risk categories and required a minimum 8% capital adequacy ratio. This required banks to allocate capital based on the credit risk category of each loan.
Corporate loans were characterized as either a Low-Risk Loan, generally to an investment grade corporate borrower, or a High-Risk Loan, generally to a middle market borrower with a speculative credit rating (BB+ or below). The effect on capital provisioning by banks can be seen below, with the net-net being that lending to Prime (or Investment Grade) companies required a bank to hold less capital than before while lending to Sub-Investment Grade companies required a bank to hold more.
This had a direct effect on the profitability of a bank as can be seen below:
As a result of this regulation, bigger banks with a national presence started to pivot away from lending to middle market companies and towards larger, investment-grade companies. Regional banks did not have this option since they could not attract this kind of client and so continued to lend to the middle market - only less profitably.
Another regulation introduced in the 80s, the Highly Leveraged Transactions (HLT) Rule, further restricted the ability of banks to lend to middle market companies since it discouraged banks from lending to companies where debt exceeded 6x EBITDA. This prevented banks from participating fully in the go-go era of the corporate raiders since many of these transactions were in excess of the 6x EBITDA threshold. As a result, Icahn, Pickens and the gang turned to Milken rather than the banks.
The 1990s - Early 2000s: Further Regulation Shapes the Banking Landscape
As we entered the 90s and 2000s, more regulation spurred further innovation in financial services. The passage of laws like the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, which allowed for branch banking to expand beyond state lines, spawned a wave of bank consolidation.
With this law, the era of the regional bank roll-up was borne. From 1999 to 2024, the FDIC counted a total of 8,254 “business combinations” between commercial and industrial banks, savings and loans institutions, thrifts and credit unions. Today, the largest 4 banks in the US control over 35% of all US bank deposits.
As banks got bigger, they shifted their focus further away from middle market companies and towards larger loans with bigger companies. Banks found it more efficient to originate a $2 billion loan compared to a $200 million loan, as the time investment was similar but the returns ten times greater. In addition, large corporate clients offered more cross-sell opportunities in things like M&A advisory, equity capital markets, and treasury management.
As banks concentrated on this scale banking, they reduced staff and streamlined processes that were previously geared towards smaller, mid-market loans. Larger, national banks increasingly adopted an originate-to-distribute model where they would originate and then syndicate loans to institutional buyers in whole loan form or package them into Collateralized Loan Obligations (CLOs). This way, they could earn fees without tying up increasingly expensive balance sheet capital.
Regional banks were not equipped to pursue the same model and so pivoted some of their lending to areas deemed safer by regulators, such as commercial real estate lending (as an aside, this is why so much of the pending commercial real estate loan crisis is held on regional bank balance sheets).
When the next iteration of the Basel Accords (Basel II) was introduced in 2004, it further constrained bank lending to the middle market through higher capital charges on risky loans. As banks pulled back further from middle market lending, non-banks increasingly entered the picture to service companies desperate to borrow in a booming economy.
Many brand name private credit firms were founded during this time: Apollo (1990), Crescent (1991), Cerberus (1992), Oaktree (1995), Ares (1997), Blackstone Credit / GSO (2005). Interestingly, though perhaps not surprisingly, every one of these firms was started by Drexel alumni. Unburdened by Basel regulations, these firms could deliver more flexible solutions to a wider swathe of borrowers. They ran lean teams that could underwrite and close loans in weeks rather than months. While they charged more in interest than banks, the tradeoff was often well worth it to CEOs looking to grow in a heady environment.
One of the early niches for these firms was in mezzanine lending, a form of debt that sits between senior bank loans and equity. Banks were rarely able to provide such financing given the higher-risk, subordinated nature of the capital - which received the highest possible capital charge on their balance sheets.
Early mezzanine funds like Crescent Mezzanine stepped in to fill this role and became a critical tool for private equity sponsors attempting to complete an acquisition. They charged a spread of many hundreds of basis points to senior loans and often received warrants as part of their financing package. While expensive, mezzanine financing provided a helpful solution since unlike traditional debt, which often required strict repayment schedules and provided little flexibility, mezzanine financing could be structured with payment-in-kind (PIK) interest, deferrals or equity kickers (warrants).
This flexibility aligned well with the cashflow uncertainty of many middle market companies (particularly technology startups in the booming dotcom era). Mezzanine capital was also useful to the venture capital backers that provided the bulk of the capital for these tech startups since adding a “mezz” layer meant less equity dilution for the equity holders. Because of the higher risk, mezz lenders could target equity—like returns of mid-to-high teens, making them an attractive investment option for institutional capital in a low yield environment.
As you can see from the below snapshot pulled from Preqin, the majority of private credit capital in the 2000s was concentrated in this area.
Mezzanine lending remained the dominant form of private credit throughout much of the 2000s until the Great Financial Crisis.
2008 Aftermath: Crisis and Opportunity
Despite the best intentions of regulators in the decades leading up to the Great Financial Crisis, efforts to stabilize the global banking system through the Basel Accords and other associated regulations failed to prevent the ensuing calamity following the filing of Lehman Brothers in September 2008. In the handwringing that followed, it was decided that more regulation was the answer.
Basel III was introduced in 2010 to make further enhancements to the existing Basel framework and reduce systemic risk. Risk Weighted Asset minimums were increased to 10.5% from 8%, certain types of high-risk assets like securitizations were given higher risk weightings and liquidity (rather than just credit) was actively tracked with minimum standards to ensure that banks could meet near-term liquidity needs.
This further reduced banks willingness to lend to corporate borrowers in favor of more liquid securities. The Dodd-Frank Act, which restricted proprietary trading and subjected banks to regular stress testing and oversight further reduced their appetite for engaging with riskier corporate borrowers. Some of the largest banks, those deemed Systemically Important Financial Institutions (SIFIs) were further constrained from risky activities through higher capital charges and enhanced oversight.
A table summarizing the effect on risk provisioning over the course of the Basel Implementation can be seen below:
Many banks that had been holding on to middle market lending activities threw in the towel at this point. It was too expensive to hold middle market loans on balance sheet. They exited or scaled back lending to these companies entirely, creating a larger void for private credit to enter.
2010 - 2021: Up and to the Right
The stage was now set for private credit to come into its own. Regulation had significantly weakened their main competitor (i.e. the banks). Companies were clamoring for capital in the stimulated environment post GFC, but finding it difficult to source. Institutional capital was increasingly comfortable with leveraged lending after decades of exposure. And rock bottom interest rates encouraged investors out on the risk spectrum. Likely the biggest driver of all, however, was demand for loans from another asset class in the alternatives space: Private Equity.
Turned into an asset class by the likes of KKR, Blackstone and others, private equity underwent a renaissance in the aftermath of the GFC. The industry had grown beyond its rough-and-tumble image of the corporate raiders of the past. PE titans were now regular attendees at Davos and other conferences, opining on ways to improve American business by streamlining operations and cutting waste.
Private equity firms aim to earn net returns of 15%+ by bringing best practices to businesses that were formerly family-owned or founder-led. They hope to improve the profitability of the companies they purchase by driving revenue growth and cutting costs — with the end goal of selling the newly scaled business at a higher multiple than where they bought it.
A big part of the special sauce, however, is debt. Private equity firms typically finance their transactions with 60-70% debt and 30-40% equity. And with banks pulling back, private equity became increasingly cozy with private credit providers.
The symbiotic relationship between private equity and private credit can be seen in the graph below. From 2009 to 2024, private equity AUM grew from $938bn to $2.6trn (~3x increase) while private credit grew from $314bn to $1.6trn (~5x increase) with a correlation of 1.
Over time, private credit has become the preferred financing vehicle for private equity. Private credit loans are more expensive than bank loans, but offer benefits such as certainty of close, shorter time to execution and more flexible terms that banks often cannot match. Unlike in the early stages of the industry when private credit was majority mezzanine loans tucked in behind a bank loan, private credit has evolved to be majority first lien senior secured (a direct competitor / replacement to the bank loans they used to sit behind). Today, Direct Lending is the biggest form of private credit.
This shift in how business owners choose to debt finance themselves speaks to a broader shift in how companies choose to finance themselves more generally. With the increasing size, sophistication and depth of debt and equity capital in private markets, many companies are choosing to remain private rather than go public.
It used to be the case that companies wanted to become public so that they could access the cheapest equity and debt capital - to become legitimate. Now that delta is much less than it was before in terms of financing cost - and the regulatory burden of being a public company is very real. As a result, companies are increasingly finding it better to stay private.
Think of many of the top companies today: ByteDance ($300bn valuation), SpaceX ($250bn valuation), OpenAI ($157bn). According to The Global Economy, the number of publicly listed companies in the United States has gone from 8,090 in 1996 to 4,642 by 2022 - a reduction of over 40% in 26 years. In large part, the reason more companies are choosing to remain private (or de-list) is because of how much easier private equity and private credit has made financing private companies. The product is simply too good.
Where We are Today and Looking into the Future
Today, private credit assets have swelled to $1.6trn - in line with the amount of leveraged loans and high yield bonds. BlackRock has said publicly that they think AUM could get to $3.5trn by 2028. It is a good time to be in private credit and a good time to sell Patagonia vests in midtown Manhattan.
Lending to middle market companies has advanced a long way since it was just a twinkle in the eye of Michael Milken in the 1970s, aided by regulatory changes that eliminated banks as a source of capital for the middle market - and by the rise of private equity. The future looks bright as well.
There are 3 big trends that are likely to provide the next leg of growth for private credit.
1.) Investment Grade Private Credit: Apollo is making a big push to do IG issuance of private credit in addition to the below investment grade lending that is the bulk of private credit today. They have insurance capital that is very interested since it would enable them to earn a spread over similarly risky public assets. And this would be a big deal for issuers since it would mean faster execution with potentially lower fees.
2.) Bank partnerships with private credit: Banks such as Citi, JPM and others are partnering with private credit funds, renting their origination capabilities and relationships to private credit funds (which underwrite and hold the loans) in exchange for fees. This aligns with the new-normal for banks, which is geared towards earning fees rather than holding risk.
3.) Asset-based lending: The vast majority of private credit today is considered “cashflow based lending”: lending to middle market companies at leverage levels based on EBITDA. But there are other areas of private credit that banks used to be able to do that are becoming orphaned or increasingly expensive from a capital charge standpoint like equipment leasing or receivables factoring. This is a much bigger portion of the market than cashflow lending. As a result, you are seeing a number of groups buying asset based lending platforms like Blue Owl buying Atalaya and Brookfield buying Castlelake. The asset growth push is on for all players and the jockeying for position will likely only get more intense.
Hopefully, this post set the stage for what to expect from this substack. It was meant as a survey of the space and I aim to cover specific areas of lending in the future. I find the niches of private credit the most interesting — areas like litigation finance, equipment leasing, music royalties and the like — so expect to see a deep dive into areas like that over time. I’ll also try to keep it topical with my take on big news in the private credit space. Til then.