Private Credit Report 2009 — Lending Because Banks Cannot

Private credit as a substantial industry begins here, and its origin explains its structure.

The starting condition was a banking system that could not lend and could not hold. Per the Global Investment Outlook 2008 and the UK Investment Report 2008, banks faced simultaneous capital shortages, funding pressure and regulatory attention. Their rational response was to shrink — to reduce risk-weighted assets, sell what could be sold, and lend far less.

This left two distinct opportunities, and it is worth separating them because they are different businesses:

Buying existing assets from forced sellers. Banks held loans they wished to be rid of — the hung buyout debt described in the Private Equity Report 2008, distressed corporate loans, and portfolios of performing assets that were simply expensive in capital terms. They were sold at prices reflecting the seller's constraints rather than the assets' value.

Making new loans to borrowers banks would no longer serve. Mid-sized companies that had borrowed from banks routinely found the credit unavailable at any price. A lender with capital could charge substantially more than pre-crisis terms for the same borrower.

The structural question is why a fund could do this when a bank could not, and the answer is entirely about funding rather than about credit skill:

• A closed-end fund's capital is committed for a decade. No investor can withdraw it.
• So the fund can hold an illiquid asset to maturity without ever needing to sell into a bad market.
• It has no regulatory capital requirement against the asset.
• And it is not marked in a way that triggers anything — no covenant, no capital ratio, no forced sale.

This is the maturity-mismatch problem from the Global Investment Outlook 2008, solved by construction. The fund's liabilities are longer than its assets, which is the opposite of a bank and is the entire structural advantage.

The advantage was in the liabilities

The point is worth developing because it determines what the industry can and cannot do.

A bank's structure:

• Funded by deposits and short-term wholesale borrowing — demandable or short-dated.
• Assets are loans — long-dated and illiquid.
• So there is a maturity mismatch, requiring liquidity buffers, deposit insurance and a lender of last resort.
• And it holds regulatory capital against every asset, scaled by risk weight.

A closed-end credit fund's structure:

• Funded by commitments locked for the fund's life.
• Assets are loans — long-dated and illiquid.
• The maturity of liabilities exceeds or matches the assets, so there is no mismatch.
• And there is no regulatory capital requirement.

What follows from this:

• The fund never faces a forced sale, which means it can hold through a dislocation and realise value at maturity rather than at the worst moment.
• It can hold assets that are expensive for a bank to hold in capital terms, regardless of whether they are actually risky.
• And it can accept illiquidity, since its investors have accepted it too.

The private credit industry's founding advantage was not that its lenders were better at assessing credit. It was that their money could not run away. Everything else follows from that.

The corresponding limitations are real and were less discussed:

• A fund cannot create money or take deposits, so it cannot lend at scale the way a banking system does.
• Its cost of capital is much higher, since equity investors expect equity-like returns — so it can only serve borrowers who cannot get bank credit or who value speed and flexibility enough to pay for it.
• And it has finite life, so it must eventually realise, which constrains the maturity it can lend at.

The last point produced the eventual structural evolution toward permanent capital vehicles and evergreen funds, which the Private Credit Report 2016 and 2020 cover.

Regulatory capital, not credit quality

A crucial and frequently misunderstood point about what moved off bank balance sheets.

The intuitive assumption is that banks sold their bad assets and kept their good ones, so what moved to funds was lower quality.

What actually drove the decisions was regulatory capital cost. A bank shrinking its balance sheet minimises risk-weighted assets, and the assets to shed are those with the highest capital charge relative to their return — which is not the same as the assets with the highest credit risk.

Assets that were expensive in capital terms:

• Anything with a high risk weight under the applicable framework, including some perfectly performing lending.
• Long-dated exposures, which attracted higher charges.
• Non-standard or bespoke structures, which were harder to model and defaulted to conservative treatment.
• And exposures in categories under supervisory scrutiny, regardless of individual quality.

Assets that were cheap in capital terms were retained, including some that were genuinely risky but happened to be treated favourably.

So the selection was driven by a regulatory formula rather than a credit judgment, which had two consequences:

• Some assets sold to funds were good credits that simply did not fit a constrained balance sheet. The buyer was being paid to hold something the seller could not afford to hold, which is a genuine and repeatable source of return.
• And the framework's imperfections became a business. Where a capital charge exceeded the underlying risk, the gap was a transferable arbitrage.

This generalises into a durable principle:

When a regulated entity is constrained by a formula, assets move according to the formula rather than according to their risk. The buyer's return is the difference between the two — which is real, and lasts exactly as long as the constraint does.

The Private Credit Report 2013 covers the same mechanism operating at much larger scale as post-crisis capital rules were implemented, and the Global Investment Outlook 2016 covers the systemic consequences of credit migrating outside the regulated perimeter.

Distressed debt is an equity strategy

The distressed strategies of this period deserve clarification, because they are frequently described as credit investing and are not.

The mechanism: buy the debt of a company likely to restructure, at a price well below face value. In the restructuring, debt is converted to equity — and the holder of the debt that converts becomes the owner.

Why the entry point in the capital structure is the entire thesis:

• In a restructuring, claims are satisfied in order of seniority. Senior claims are paid first, then subordinated, then equity.
• Somewhere in that stack, the value runs out. The class where it runs out — the fulcrum security — is the one that converts to equity and receives ownership.
• Classes above are paid in full; classes below receive little or nothing.

So the analysis required is not "will this company repay" but "what is this business worth, and which class of claim sits exactly at that value."

This is an equity valuation exercise — estimating enterprise value — combined with a legal analysis of the claim structure. The credit question is almost incidental.

What makes it difficult:

• Enterprise value must be estimated for a distressed business, where recent financials are unrepresentative.
• The claim structure may be contested, with disputes over seniority, guarantees and collateral that are resolved legally rather than economically.
• The process is slow, taking a year or more, during which the business may deteriorate further.
• And it requires the ability to participate in negotiations, which needs scale, expertise and often a blocking position in the relevant class.

Why 2009 was an exceptional entry point:

• Prices reflected forced selling rather than fundamental value, per the bank constraints above.
• The businesses were frequently sound and failing for balance sheet reasons — the distinction the US Venture Capital Report 2008 draws between asset-side and liability-side damage.
• And the eventual recovery was strong, so enterprise values recovered.

These conditions do not persist, which the Private Credit Report 2020 and Secondaries Market Report 2023 both examine when similar strategies faced much more competition.

Two premiums, frequently confused

A conceptual distinction that determined how well investors understood their own returns.

The illiquidity premium is compensation for accepting that you cannot sell. It is genuine and structural: an investor who can hold to maturity provides something valuable — patient capital — and should be paid for it. The payment is real return for a real service.

The complexity premium is the extra yield available on assets that are hard to analyse. It is not compensation for a service. It is available because fewer buyers can do the work, and it is only a genuine return if the analysis is actually correct.

Why conflating them matters:

• An illiquidity premium is earned by structure — by having locked capital. Any fund with the right liabilities can capture it.
• A complexity premium is earned by capability, and only if the capability is real. If the analysis is wrong, the extra yield is compensation for a risk that was mispriced, and it will be given back.

The illiquidity premium is paid for waiting. The complexity premium is paid for being right. Only one of them is available to everyone who shows up with patient money.

The measurement problem is that both look identical in a return series during a period when nothing goes wrong. A fund earning a complexity premium on assets it has misjudged reports excellent returns until the losses arrive, which can be years.

The practical distinction is to ask what the fund is being paid for. If the answer is "we can hold this and a bank cannot," that is the illiquidity premium and it is durable while the constraint lasts. If it is "we understand this and others do not," that requires evidence, and the evidence only arrives through a full cycle.

Origin conditions and the expectations they set

The industry's founding period was unusually favourable, and the returns of that period became the benchmark for everything after — which was a problem.

What made 2009–2011 exceptional:

• Sellers were constrained, so prices reflected their circumstances rather than the assets.
• Competition was minimal, since very few buyers had capital and the willingness to deploy it.
• The macro recovery was strong, so credit performance exceeded underwriting assumptions almost universally.
• And leverage on the funds themselves was cheap as rates fell.

All four conditions were transient, and each faded for its own reasons:

• Bank constraints eased as capital was rebuilt, though the regulatory framework kept some permanently.
• Capital flooded in, attracted by the returns — which is the standard mechanism by which an excess return is competed away.
• The recovery matured, so credit outcomes normalised.
• And the cheap leverage became universally available, so it stopped being an advantage.

The expectations problem is structural rather than a matter of anyone's dishonesty:

An asset class whose first vintages are formed during forced selling will report returns that the competitive, mature version of that class cannot repeat. The early numbers are a record of the conditions, not of the strategy.

This is the same structure as the crisis-vintage analysis in the US Venture Capital Report 2009 — a vintage effect misattributed to skill. The difference is that in venture it was understood as a vintage effect, and in private credit it was frequently presented as the asset class's normal return profile.

The Private Credit Report 2016, 2020 and 2022 track what happened as the conditions faded and the industry grew to a scale that required lending to borrowers banks would happily have served.

What an allocator could act on

Identify the structural source of a return before crediting it to skill. Locked-up capital holding illiquid assets is a funding advantage available to anyone with the right liability structure.

Follow regulatory capital costs, not credit quality, to predict what banks will sell. Assets move according to the formula constraining the seller, which means some of what is sold is genuinely good credit.

Analyse distressed positions as equity valuation plus claim structure. The fulcrum security determines ownership, and identifying it is an enterprise value exercise rather than a credit one.

Separate the illiquidity premium from the complexity premium. The first is paid for waiting and is durable; the second is paid for being right and requires a full cycle of evidence.

Discount founding-vintage returns when assessing an asset class. Returns earned during forced selling record the conditions rather than the strategy, and the competitive version cannot repeat them.

Ask what constraint a strategy depends on, and whether it is permanent. A return arising from someone else's regulatory or funding constraint lasts exactly as long as that constraint does.

What 2009 established

• The founding advantage was liability structure, not credit skill — locked capital can hold what demandable funding cannot.
• Regulatory capital cost determined what moved, so some assets sold were good credits the seller could not afford.
• Distressed investing is equity valuation through a debt instrument, with the fulcrum security as the thesis.
• The illiquidity and complexity premiums are distinct, and only the first is available by structure alone.
• The founding conditions were transient, and the returns they produced set expectations the mature industry could not meet.