The post-GFC era of low defaults meant nearly every private credit manager performed well. That era is over. For the first time in over a decade, manager and asset selection are critical, which will lead to a wide dispersion in fund performance and a shakeout in the industry.
While intense competition has shrunk the illiquidity premium in mainstream private credit, esoteric strategies like asset-based lending (ABL) offer a "complexity premium." This niche has fewer competitors, allowing for excess returns that are decoupled from broader market pressures.
To avoid becoming an "asset accumulation business," SLR Capital requires all employees to invest a significant part of their compensation back into the firm's funds. This forces everyone to act as a principal and ask, "Would I personally own this loan?" creating a powerful filter against risky deals.
Contrary to the "scale is everything" mantra, large private credit funds face diseconomies of scale. The pressure to deploy billions forces them to chase crowded, mainstream deals, leaving complex but lucrative niches like direct-origination ABL to smaller, more specialized firms that can manage the complexity.
Concerns that Business Development Companies (BDCs) will trigger a financial crisis are unfounded. Unlike banks levered 10-to-1 pre-2008, BDCs are legally capped at 2-to-1 leverage and typically operate closer to 1-to-1, minimizing systemic financial risk even if underlying loans default.
The regional banking crisis and subsequent regulatory scrutiny forced many banks to exit complex, capital-intensive businesses like asset-based lending to smaller companies. This retreat has eliminated key competition for non-bank lenders, who can step in to fill the void without the same regulatory burdens.
Unlike private equity, where big wins can offset losses, credit investing has an asymmetric return profile: the upside is a modest coupon, while the downside is a total loss. This means investors must be right nearly 100% of the time, demanding a culture where any ambiguity or "hair" on a deal results in a swift "no."
To combat fraud, some credit funds use the prospective borrower's due diligence deposit to fund deep background checks on founders and management as the very first step. Any past financial impropriety, no matter how old, results in an immediate rejection, making recent high-profile frauds avoidable.
While default rates are a concern, the bigger issue is that loss-given-default will be higher. Historically, bank loans recovered 70% because covenants allowed early intervention. Today's covenant-lite private credit loans prevent this, likely pushing recovery rates down from 70% to the 40-50% range.