Private credit’s new frontier: growth lending as a source of diversification

In the face of rollercoaster markets and general instability, many institutions continue to explore ways to branch out by broadening their alternatives exposure.

Private credit has become a popular place for many allocators to look in recent years. Across a diverse range of asset classes, the potential addressable market now well exceeds US$30 trillion. And importantly for diversification, the opportunity set has grown way beyond the traditional – and increasingly crowded – middle market direct lending space.
 

_{Source: McKinsey & Company, September 2024, “The next era of private credit”.}

As the lens into the private credit landscape widens, an emerging option for investors to explore is growth lending.

Put simply, as a subset of direct lending, the form of corporate debt where non-bank lenders give loans to companies without an intermediary, growth lending is providing privately originated debt to venture-backed, late stage, high-growth companies that are choosing to stay private for longer. While not as well-trodden as middle market direct lending, the US hit a record in 2024 for such venture debt, surpassing $53 billion in capital deployed, with 91% flowing to late-stage companies, according to PitchBook’s NVCA Venture Monitor.

Notably, the tailwinds are strong. Among them is an ever-larger lending gap, which has emerged since the collapse of Silicon Valley Bank, and the decline in venture capital (VC) equity funding in recent years that has left many companies starved of the support they used to attract.
 

_{Sources: Pitchbook Data, Inc. | 1According to Ptichbook-NVCA’s analysis, in Q4 2024, the capital demand/supply ratio hit 2.7x for both late-stage growth and venture-growth. | PAST RESULTS DO NOT PREDICT FUTURE RETURNS. | Data is that of a third party. While data is believed to be reliable, no assurance is being provided as to its accuracy or completeness. Information provided as of the date noted. | This material is not suitable for a retail audience}

To further explore the drivers and potential for growth lending, AsianInvestor asked Wellington Management’s Xiaying Zhang, director of private investments in the firm’s APAC client group, about the market dynamics that create a compelling case for this asset class.

AsianInvestor (AI): Is private credit overcrowded? Does the opportunity for outperformance still exist?

Xiaying Zhang (XZ): We anticipate that the growth of private credit may continue in 2025, reflecting a decade-plus trend. The steady expansion of the asset class suggests a growing recognition of the role it can play as both a complement and diversifier to traditional credit investments.

Crucially, as it grows, private credit appears to be broadening in scope, with new areas of growth emerging based on structural and near-term trends. We believe the next phase could increasingly encompass sectors at the intersection of public and private markets, as well as in partnership with bank originators.

We see a key attraction of private credit as being rooted in its flexible structuring. The asset class offers borrowers the opportunity to tailor their financing structures over a longer time horizon, outside of the volatility experienced in public markets.
 

_{Sources: PitchBook, World Federation of Exchanges, World Bank, 2024 data as of 30 September 2024.}

AI: Which themes are exciting for investor to watch in 2025?

XZ: One area where the convergence of public and private credit appears to remain pronounced is within broadly syndicated loans and middle market direct lending. As a result, CLO equity could potentially be a significant beneficiary of the growth in private credit.

In addition, the artificial intelligence (AI) theme will likely accelerate different capital solutions – including private debt – to fund inevitable growth in the need to develop infrastructure for data centres, expand the electric grid and build new energy capacity, among many other use cases. This transition to support the AI theme may contribute to accelerating growth in diverse areas of private credit, including commercial real estate.

More broadly, another opportunity could come from focusing on high-quality, fixed-rate assets or sectors with a low correlation to movements in interest rates.

AI: What’s the appeal of growth lending as the private credit opportunity-set expands?

XZ: There is a clear trend among venture capital-backed, high-growth companies to stay private for longer. Increasingly, they seem to prefer this route as they pursue their hyper-growth phase, rather than be subject to the quarterly earnings and other shorter-term expectations of public markets.

One reason for rising demand for debt in venture investing is because VC and growth equity funding have slowed significantly in recent years, creating a large imbalance between the supply and demand of capital. With equity more expensive, founders are seeking less-dilutive capital solutions.

The potential for attractive risk-adjusted returns is another tailwind which likely will fuel appetite for growth lending. For example, investors typically get a quarterly income distribution at a premium to public credit markets, with additional alpha potentially coming from equity upside, often in the form of warrants.
 

_{PAST PERFORMANCE DOES NOT PREDICT FUTURE RETURNS. Performance information reflects indices and does not reflect any Wellington investment strategy. Generally, an index is unmanaged and cannot be invested into directly. 1 Source: Cliffwater, Pitchbook, Bloomberg, ICE BofA,Wall Street Journal; U.S. Agg represented by the Bloomberg US Aggregate Bond Index as of 3Q 2024, U.S. Corporate is represented by the Bloomberg US Corporate Index as of 3Q 2024; High Yield is represented by the ICE BofA Global High Yield Index as of 3Q 2024, Direct Lending is represented by Cliffwater Direct Lending Index as of Q3 2023, Growth Lending is represented by Cliffwater Direct Lending Index – Venture Lending as of Q3 2024. 2Source: Average on the Last 10 years as of Q3 2024: Cliffwater; 2023 Q4 Report on US Direct Lending and Federal Reserve (Fred: CORBLACBS); Average on the Last 10 years as of Q3 2024.}

AI: Isn’t growth lending just a lot riskier and more volatile?

XZ: This is a common misconception. However, this asset class has intrinsic downside protections which, compared with other areas of public and private credit, have kept historic default rates low while still enhancing yields.

In short, growth lending focuses on mature private companies in high-growth sectors, including life science, healthcare and technology. Such high-quality companies are able to raise equity, but they chose to raise debt instead to avoid dilution. Many of these business have also previously gone through several equity financing rounds and generated enterprise value through development of commercially available products. Some of these mature companies have created a moat and have defensible value through their intellectual property, proprietary technology or market share, which tend to provide a competitive advantage that enable them to maintain healthy and scalable unit economics. 

Specific downside protections features that  growth lending may offer:

• These are typically senior secured loans with a first-priority lien over all company assets.
• The lending involves low loan-to-value (LTV) ratios (often less than 25%), providing a cushion if a business deviates from its plan.
• Growth lenders focus on company fundamentals, enterprise value and sponsors, ensuring the underwriting process considers both the debt servicing capability and value protection. Unlike a traditional credit underwriting process, growth lenders are more similar to equity underwriters, where they have direct access to management, clients and equity sponsors.
• The loans involve multiple disbursements based on milestones. This is designed to prevent a company becoming overleveraged and, therefore, help reduce the investment risk. Further, growth loans tend to have a maturity of five years, but are often prepaid in less than 36 months, and in doing so can help to enhance returns via prepayment fees and provide more diversification.
• Growth loan covenants include minimum liquidity, growth/performance covenants and standard restrictive covenants to monitor and protect a lender's interests. In addition, as a single lender market, growth lending allows for more tailored structures and nimble term negotiation and workouts, unlike middle market direct lending, where loans are broadly syndicated and lenders need to agree on terms.

AI: What are the fundamentals in assessing growth lending opportunities that investors need to follow?

XZ: We look for borrowers who are seeking debt capital to accelerate growth and continue scaling their businesses without further equity dilution. In general, they also need to have a profile that displays several features: a resilient business model; established management teams; proven product and market positioning; strong unit economics and pricing power; and high and consistent growth.

Managing a growth lending strategy requires specialised and experienced lenders to source, underwrite and manage growth loans successfully. Accessing high-quality companies is key for the success of this strategy to maintain credit quality and upside convexity.

A solid underwriting track record is particularly important given that growth borrowers typically have negative EBITDA and limited cash runways. This requires in-depth understanding of these risks and knowledge of the venture capital landscape.

At Wellington, for example, our sourcing channels span private and public markets, and we believe are differentiated relative to traditional private debt lenders.

This includes over a decade of experience investing in private equity of these growth companies. And having invested in over 100 companies and taken over 50 of those companies public, our approach is anchored in a deep bench of proprietary resources that can underwrite the key risks and opportunities for a business – including over 25 private investment managers, more than 80 credit portfolio managers and analysts, and in excess of 50 global industry analysts.

This also ensures we don’t fall into the trap of blindly accepting valuations that come from VC firms. We use our experience and resources to fully underwrite the company, to derive our own valuation and, in turn, determine a comfortable LTV range.

This tailored approach also enables us to build-in protective covenants where needed, which may include minimum liquidity and growth performance covenants.

Click here to learn more about Private Investing at Wellington Management

_{For professional, institutional and accredited investors only. Any views expressed herein are those of the author(s), are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. Certain data provided is that of a third party. While data is believed to be reliable, no assurance is being provided as to its accuracy or completeness. Forward-looking statements should not be considered as guarantees or predictions of future events.}