The power of private funding to reshape debt capital markets is indisputable. After exponentially expanding in recent years to compete with public markets in size, scale, and speed to execute, private funding is now pushing into new parts of the credit markets. New opportunities for private funding in asset-based finance and project finance are supporting the changing dynamics and structure of capital markets overall, and the continued evolution of private markets specifically.

With the potential market size of asset-based finance and project finance funding for infrastructure estimated to exceed $30 trillion, its potential position far exceeds leveraged finance for corporate credit (where over two-thirds of the $1.4 trillion broadly syndicated leveraged loan market is already held in collateralized loan obligations). Based on the traditional structure of originating and distributing asset-based finance and project finance lending, banks have long been the legacy leaders of such lending. But as capital charges weigh on new deal activity and banks seek to derisk, alternative asset managers are increasingly taking this share--by disintermediating (or partnering with) banks with the capabilities that these private players have built to both originate and to distribute debt with investors through their private credit platforms.

This structural shift hasn't happened overnight and is the latest development in private funding's evolution that is presently upending traditional market relationships and roles. While this shift brings the potential for new capital to meet funding needs, we believe the extension of private credit to lesser-understood or more complex assets can also carry new risks.

With Origination And Distribution Capabilities, Private Players Provide New Path To Funding

By providing multiple types of credit, arranging, and originating, alternative asset managers are filling roles traditionally operated by banks--and in cases where more debt is originated than can be placed within the lending platform, some are broadening the distributions of their originations to outside investors.

Traditionally, an asset-based or project finance transaction would originate at a bank or a specialty lender, which would work with the borrower to structure a deal that could then be distributed by a bank or investment bank among a broad mix of investors. These conventional originations can also extend into more private markets through private placements, which involve the private sales and distribution of the instruments across a limited base of end-investors.

More frequently now, the alternative asset manager arranges the transaction from origination to placement across its credit platform in a direct origination of a private market asset-based or project financing.

Several influential factors are enabling this change—particularly the return of alpha, regulatory shifts, and the rebalancing of the market structure.

Private markets are known for their outperformance. This is balanced by their high competitiveness, due to both the amount of capital and dry powder that has been raised, alongside the demand from public markets for deals. As a result, spreads and yields have tightened--and lenders have been pushed to look at riskier borrowers. The lesser-understood, more complex areas of asset-based finance and project finance (which are also underserved by private markets) have emerged as a compelling investment opportunity because they generally generate higher returns, and thus are more attractive than other parts of the private markets in creating the opportunity for alpha.

At the same time, banks are looking to derisk as a result of the implementation of more stringent capital rules in the aftermath of the Global Financial Crisis, which has created opportunities for nonbank lenders to increase their presence in riskier areas. Similarly, some market participants believe that if the Basel III endgame proposal is stringently implemented, some banks may step back from many forms of asset-based lending in order to preserve capital.

Alternative investment managers are able to make inroads in this space after growing in size, scaling up in sophistication, and increasing their capacity to fund larger and larger transactions over the last decade. Through acquisitions, partnerships, and joint ventures, several of these companies have also established arms that provide origination, while also managing funds that can operate as the actual investors in this credit. Due to their capabilities for origination and ownership of distribution channels that place the new issues within related funds and insurance portfolios, some alternative asset managers today resemble a vertically integrated credit shop. This is particularly evident where the asset manager structures the private credit asset-based finance and/or project financings to fit within the portfolios of related insurance companies.

Searching For Alpha

Flush with capital, private credit providers are looking to expand into other untapped areas spanning consumer, auto, commercial, and esoteric credit backing asset-based lending, along with energy, social, and infrastructure backing project finance. While corporate credit offers a substantial addressable market, these sectors offer the potential for an even larger market. Together, asset-based lending and project finance could account for a market that is larger than the corporate credit market.

For comparison, the leveraged finance market globally has averaged just under $900 billion in annual issuance in recent years, where issuance of infrastructure, international public finance, and structured exceed $2 trillion annually.

Outside of the traditional corporate private credit market, the prospect of higher alpha entices.

For traditional private credit to corporates, yields are down and spreads have tightened since the so-called "golden age of private credit" in 2023. At the time, private credit lenders faced limited competition from a broadly syndicated loan market in which new issuance volumes dragged.

This year, corporate spreads tightened as both broadly syndicated loan and high-yield bond issuance rebounded, and the search for alpha leads private credit lenders to new territory.

Regulatory Shifts Prompt Another Step In The Development Of Private Markets

The history of financial markets traces an evolution along the long arc of bank regulation. Following the Global Financial Crisis, capital markets were transformed for many borrowers. With banks facing stress tests, higher capital charges, risk retention requirements, and leverage limits after the passage of the Dodd-Frank Act, less corporate credit was on offer. Funding liquidity dried up for small to midsize corporate borrowers as prominent lenders exited the market following the crisis. As lenders retreated, alternative asset managers sensed an opportunity. Private credit was not new, and it already had a reputation as "bear market capital". For borrowers with few other sources of funding readily available, credit was (and still is) credit. The direct lending market grew, and private credit's role became a more integral part of the corporate leveraged finance market.

The direct origination of private credit to asset-based finance and project finance now appears to mirror the rise of private credit direct lending to corporates that previously redefined markets.

Where capital needs and leverage limits may curtail a bank's flexibility in its credit offerings, the alternative asset managers that extend private credit have a reputation for providing flexible credit solutions, particularly when markets become riskier and banks pull back.

Now, some market participants are suggesting that the proposed Basel III endgame will lead to another wave of the expansion of private credit, this time into credit viewed as having more predictable, contractual cash flows, such as more asset-based and project finance. (In September 2024, the Federal Reserve Vice Chair for Supervision Michael Barr indicated the rule would be re-proposed with less impact. For instance, it would increase capital requirements for the global systemically important banks by 9% in aggregate, versus 19% in the original proposal. Mr. Barr also said the re-proposal would exclude banks with assets of $100 billion - $250 billion from most of the proposed changes.) To be sure, it remains unclear how Basel III may impact banks' lending capacity.

Changing Market Dynamics Are Rebalancing Market Participants And Reshuffling Balance Of Power

Thirty years ago, the broadly syndicated loan (BSL) market began the rebalancing of power between banks and institutional investors. The BSL's evolution--from bank loan, to loan participation, to loan syndication, to broadly syndicated loan--reflects the changing market dynamics from bank-funded M&As and working capital to primarily driven by institutional money. The BSL market's road to dominance over debt capital markets for speculative-grade borrowers not only created a more dynamic and diverse funding capacity, but also brought the power of investor funding to center stage. In today's public markets, banks and institutional investors have a balance of power that aligns with their separate needs and investment strategies.

Private funding is now here to reset this balance of power. The majority of the market is still geared for that traditional direct lending strategy, but several large alternative asset managers have evolved into lending platforms that facilitate a one-stop-shop for credit.

Through scale, alternative asset managers have adapted the prior "originate and distribute" model of banks to their own vertically integrated structures. Private credit is often touted for its versatility and ability to be structured to meet the needs of borrowers. Once originated, debt instruments can be placed into the portfolios of investor vehicles including private credit funds, middle-market collateralized loan obligations, and business development companies. Several asset managers have also acquired or partnered with insurance firms as another source of long-term committed capital for credit.

In the case of this direct origination, these private players benefit from the flexibility that the originator has to source and tailor a deal to meet the objectives of its ultimate investor. As another example, the duration is a feature that can be customized through the direct origination to suit the needs of the ultimate investor, and for an insurance company, the duration can be tailored to meet asset-liability management.

Given the high cost of supporting operating expenses of the business, the ability to offer a lower cost of financing is a scale-driven competitive advantage. For funding, the long-term liabilities of insurance companies may provide a better match to the long investing horizons of some project finance and asset-based finance than banks' short-term funding through demand deposits.

We believe alternative asset managers with origination platforms and capital to deploy may look to grow aggressively. The window for this expansion appears to be open as banks continue to operate cautiously. However, we would view this expansion as a potential credit risk if growth and competition lead to an erosion in underwriting standards.

Among the alternative asset managers that we rate, the largest ones have sizeable and diversified asset-based finance platforms with origination approaches built through a variety of strategies. Ownership of the platforms may be held in the funds managed by asset managers, directly by the asset manager, or in combination.

One of the clearest examples of such platforms is Apollo Global Management (A/Stable/--), which has expanded its direct origination capabilities to include 16 lending platforms across commercial and trade finance, equipment and transport finance, consumer and residential finance, and other asset-based strategies. It has pursued this growth both organically and through acquisitions. For example, Apollo acquired a large portion of the Securitized Product Group of Credit Suisse (which it has branded as ATLAS SP). Through this platform, it provides capital, financing, advisory, and institutional products (see table 1).

Table 1

While scaling their capabilities for originations, alternative asset managers have also established a channel for distribution through the funds that they manage and their pairings with insurers.

We have seen pairings between asset managers and insurers take many forms, with transactions meaningfully differentiated by the asset manager's willingness to grow its balance sheet to pursue a strategic interest in insurance (see table 2).

For instance, Apollo and KKR & Co. Inc. have expanded in the insurance space through their respective acquisitions of Athene and Global Atlantic, growing their balance sheets in the process. By contrast, other asset managers (including Blackstone Group Inc., Ares Management Corp., and Blue Owl Capital Inc.) have followed a light balance-sheet approach by signing agreements with insurers to manage their investment accounts--either with a minority investment or no investment at all in the insurance company. The Carlyle Group Inc.'s insurance strategy falls between the heavy and light balance-sheet spectrum with its majority stake in Fortitude Re (largely owned through a fund that Carlyle manages). Meanwhile, Brookfield Corp. spun off its insurance business, Brookfield Wealth Solutions, while retaining a significant economic interest in this now publicly traded entity.

Most of these asset manager pairings have been with annuity providers. However, some also provide other lines of insurance as well, such as multi-line or property and casualty.

Beyond the pure asset management capabilities, alternative managers also bring their capital raising expertise to the table. It has become increasingly common for annuity-providing life insurers to rely on outside capital raised through sidecars, and these were initially introduced by insurers that were partnered with alternative asset managers.

For asset managers, these pairings with insurers can provide several benefits, including another source of fees and long-term capital to fund lending. These relationships allow asset managers to manage and allocate the insurance companies' investment portfolios, thus providing both a source of long-term funding for their debt originations and a source of fee revenue.

Alternative asset managers claim that the long-term, perpetual capital from insurers is a good match for their illiquid investment strategies, which typically have longer-term hold and realization cycles. The long-term liabilities of insurance companies may provide a better match to the long investing horizons and illiquid nature of private credit assets.

The asset manager also benefits from scale, where it can match strategies in which it has origination capabilities, particularly credit, to an annuity provider's longer-term liability profile.

We believe, however, that the benefits of scale and assets under management (AUM) growth may be partially offset by the potentially lower fee rates associated with a higher proportion of lower-risk strategies the insurer is likely to pursue and/or due to lower fees charged on incremental AUM.

While a traditional origination is distributed to a broad mix of end-investors, direct origination leads to a narrow distribution of assets among a few investors. Through pairings with insurers, the asset manager diversifies its limited partner base. We think these strategic relationships are an early step to somewhat broaden distribution channels for both the asset manager and insurer over time.

While we see tremendous opportunity for asset managers from these relationships, we also see potential risks. Material stress that hurts an insurer's capital adequacy could create repercussions to the asset manager's investment, earnings, cash flow, and liquidity, depending upon its willingness to provide some form of support to the insurer under certain stress scenarios. In addition to the increased complexity that comes with insurance (products, accounting, and reporting), an asset manager that acquires an insurance company will face steeper regulation at that entity. That could include limits on the ability for the insurance operating company to pay dividends to its holding company. While this serves to protect the insurer's ability to meet policyholder obligations, it may curtail returns to the asset manager parent. Lastly, these relationships come with governance considerations and potential conflict of interest, given that the asset manager may earn greater fees from growing these investments quickly and allocating them to its own funds.

Table 2

Looking Ahead At New Innovations And Uncertainties

Given that changing regulatory frameworks may have opened a door for private credit, innovation is further enabling its expansion. But innovation brings unknowns, and private markets lack the systemic transparency of public markets to gauge the market broadly.

Some of the largest banks own asset management businesses and are able to maintain a revenue stream even if some of the lending is ultimately not originated in the traditional manner. At the same time, many large banks are teaming up with private credit lenders, adding to their offerings to potential clients--by either engaging with them in the traditional syndicated lending market or offering private credit. In this type of partnership, the bank usually has both a greater depth and breadth of relationship contacts and more lending expertise, while private credit has more extensive available capital to lend.

With private credit lenders reaching to provide funding to larger borrowers and expanding to include other assets (such as with asset-based finance and project finance), regulators are paying increasing attention. Further changes in the regulatory approach for banks and nonbank financial entities could lead to more shifts down the line.

In the meantime, banks will likely view alternative asset managers as competitors or partners, or some combination of both. While this will likely lead to new ways of doing business, it also opens the door for further innovation.

These opportunities for private funding are not without risks. Credit for project finance and asset-based finance is highly illiquid and complex, even in traditional public markets. These assets fund technologies and investments that are new, rapidly evolving, and (in some cases) largely unproven or untested. Systemic transparency in public markets--through market pricing, public ratings, and other disclosures that are available to the numerous parties involved in a transaction--alleviates some of the risk in public markets, or at least makes it easier to monitor the risks broadly. By contrast, transparency in private markets is more situational, managers are limited to a narrower view of the market where they have direct involvement. The access to information is not uniform, as the larger investors and largest managers see considerably more deal flow than smaller investors or managers' more limited view of the market.

Where the expansion of private market funding into project finance and asset-based finance appears to be following the roadmap set by traditional private credit in corporate finance, the path forward for public and private markets in this case leads into uncharted territory.

The traditional "private credit" is the more "mature" part of credit markets with many established investors and fund managers, and as it intersects with a large, highly liquid public market. Even in public markets, the structures of asset-based finance and project finance assets are constantly evolving--and the composition of the underlying assets is changing (including diverse assets from toll roads to data centers, each of which may have unique credit considerations). With this diversity of assets, project finance and asset-based finance transactions can be more complex to structure and manage--requiring specific data and subject matter experts in esoteric areas to model. And in addition to the diversity and complexity of assets, these can also require longer investment periods for those that are also primarily large and illiquid.

Higher returns entice new investors, and the expansion of private funding into project finance and asset-based finance brings investors with a higher tolerance for risk and a more flexible, faster funding process. This stands to dramatically change areas of both public and private funding in the coming years and interim. Where the evolution of the bond and loan markets offers some perspective for how private credit will scale up in the future, risks remain given the systemic opacity of private markets with the complexity and long-term investment horizon of project finance and asset-based finance.