Six questions companies need to ask about private credit

Blog
6 minute read
December 05, 2024

Gregory McGahan

Financial Services Deals Leader, New York, PwC US

John Gleason

Managing Director, PwC US

The demand for private credit is surging. Many private credit lenders are targeting larger companies and moving well beyond the mezzanine and private equity-oriented lending that marked the offering’s historical stronghold. There are many questions companies may have about this potential financing option.

Many CFOs and finance teams aren’t familiar with the opportunities and challenges seen in private credit transactions. Corporate borrowers need a cross-functional effort and specialized knowledge of contemporary structures, given the tailored and unregulated nature of private credit. Here are six questions the executives and boards at companies should be asking.

What is private credit and is it an option for the company’s capital needs?

In a simplistic form, private credit transactions generally take the form of:

Direct lending: The origination of a loan between a single borrower and lender (or small group of lenders without using a banking intermediary).
Asset-based lending: Sometimes referred to as multi-asset or specialty financing, this can leverage a company’s assets to secure financing. It can take many forms, including aircraft leasing, supply chain finance, revolving credit lines on eligible receivables and inventory, annual recurring revenue (ARR) financing and equipment financing.

Private credit is expanding by offering borrowers different ways to help structure loans that accept, for example, bespoke forms of collateral or payment-in-kind interest. It can provide more flexibility in negotiating terms that are acceptable to both the creditor and the lender. These methods contrast with traditional pools of capital accessed through banks or public markets. To make an informed choice, many borrowers are increasingly performing debt readiness assessments to evaluate their access to different pools of capital. This includes taking a hard look at one's business to better understand what assets can be financeable through nontraditional markets (e.g., ARR loans) as well as whether its capital needs could be rightly met through private credit.

Not all capital is created equal. Why would a company choose private credit?

Private credit can be a much more bespoke solution for credit needs as these are generally biparty deals with individually negotiated covenant packages and terms. While some CFOs may have felt more comfortable obtaining credit from traditional banks in the past, increased regulatory oversight has caused banks to pull back, allowing private credit to step in to fill the void. The solutions private credit offers can be tailored to meet a borrower’s needs in terms of size, type and timing as well as pricing certainty and speed. This tailored capital can provide increased flexibility toward meeting a specific company’s specific needs.

Executives should understand and evaluate the potential trade-offs of various credit products. Given the potential nuances involved with these deals, it’s important to conduct a holistic financial modeling exercise. A what-if analysis can help companies explore various scenarios to understand their potential impact on cash flows, returns and leverage. By simulating different financial outcomes, executives can tell the right story and present data-driven insights that can convincingly demonstrate the viability of their strategies to stakeholders. A well-executed financial model can provide the clarity and evidence needed for corporate borrowers to make informed, strategic decisions that can help drive sustainable growth.

What are the key factors to consider when evaluating a private credit opportunity? One should consider:

What does the current capital structure look like? Is the company seeking direct lending or mezzanine financing and preferred equity options that banks don’t typically participate in? Are there any covenants or restrictions on existing capital that could limit financing options? Is the credit for a specific purpose (such as a merger, acquisition or capital event)? What level of investor involvement is the company able to tolerate? A clear understanding of the company’s financing needs and the restrictions imposed by existing capital arrangements can serve as an anchor when determining the right lender to work with and negotiating key terms of the financing.

Many banks generally have standard tenors for which they will lend depending on the nature of the borrower and type of credit being provided. Private credit can provide more flexibility in the tenor of the instrument, but it may often include a prepayment premium and structural considerations from a refinancing perspective that should be assessed.

Cross-currency loans are often easier to originate when raised through the private markets with private capital. This is because banks often originate such loans in each respective market.

Corporate borrowers should assess which covenants and terms they are willing to tolerate as private credit generally includes stronger safeguards for the lender. These safeguards could include terms that provide the lender with the ability to intervene in key business decisions. Depending on the size of the borrower’s business, covenants could look like a traditional syndicated loan, but private credit often comes with traditional financial maintenance covenants that can be more restrictive in nature.

Many direct lending loans tend to be floating rate rather than fixed rate. The company should evaluate whether evolving economic trends (rising rates, slowing demand, price pressures, etc.) could affect its ability to repay the debt over time. A holistic analysis that can evaluate both capital needs and repayment risk can help the company maintain a strong balance sheet and manage default risk. One additional consideration is the company’s ability to pay the debt in-kind as opposed to outlaying cash under certain scenarios?

As with any debt, executives should include the cost of the capital in financial plan models. This should be done upfront and include all of the relevant tax considerations to help make sure that the capital being obtained is in line with the company’s financial plan. The costs of private credit, such as underwriting fees and interest expense, are often higher than those of traditional credit.

Corporate borrowers should consider the purpose of the credit and what structural flexibility might be needed. For example, private credit can layer in delayed draw components that can allow companies to have built-in financing firepower for M&A activity without the need to find new investors. Furthermore, companies should remain mindful of the potential accounting, tax and business implications that these features might introduce.

The increase in credit choices provided by tailored capital can make assessing financing alternatives more time-consuming and challenging. Consider the factors that are important for the company’s capital needs to help simplify the process.

How can raising private capital impact a company’s balance sheet?

We’re seeing an increase in the number of companies exploring opportunities to move their financing off-balance sheet. One of the reasons for this is that on-balance sheet financing can materially impact a company’s credit rating.

With asset-based lending, credit can be structured off-balance sheet through a collateralized vehicle. But these structures are highly complex and not cookie cutter arrangements. Therefore, companies should work with advisors to help evaluate the impact of different types of debt instruments and determine the potential impact on their balance sheets and existing credit ratings. It’s important to involve tax and accounting advisors early in the process when evaluating such structures and financing.

Beyond the actual capital, what other support is a company looking for from a creditor?

Banks and private credit funds usually provide more than just capital. For example, banks can bring a breadth of teams and products. Additionally, banks have traditionally been a source of bridge financing. Private equity and credit funds can bring complementary relationships through their investments. It’s important to consider the holistic value proposition of the lender the company is considering.

How does the company know if the financing terms are fair — and if shareholders and the board will agree?

Regardless of where capital is sourced, there should be an underlying trust between the counterparties. When executing financing agreements, there’s generally a healthy, inherent concern among executives regarding whether or not the terms of the arrangement are fair when answering to their board and shareholders.

Many banks will often go out to a subset of investors, which results in price discovery and competition. Arranging private credit, however, has traditionally been a bilateral negotiation. That said, we’re beginning to see more companies approaching several private lenders before picking one or a few of them, and that’s resulting in some form of price discovery in private credit. So, when considering private credit, take additional steps to evaluate whether the deal is fair and at market terms. An independent review can provide additional clarity as to the fairness of terms in the arrangement to executives, directors and shareholders.

Are there other opportunities to lower the company’s cost of capital through financial engineering?

With interest rates at elevated levels compared to most of the past decade, many companies are considering strategies that can help bring more certainty to financing. Examples include using derivatives to lower expenses or leveraging tax strategies for tax improvements through intercompany loans and moving debt to lower rate jurisdictions. Capitalizing on such opportunities can require a proactive and early assessment of the options available involving corporate finance specialists and other advisors.

The bottom line

The demand for private credit is increasing. Lenders are targeting larger companies and moving beyond traditional mezzanine and private equity-oriented lending. Companies considering this financing option should understand the complexities and opportunities involved. By considering the six questions outlined above, companies can start to make more informed decisions to help drive growth and potentially lower the cost of capital through strategic financial planning.

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