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Lee Price: Hi there, you're listening to Market Matters, our market series here on J.P. Morgan's Making Sense podcast channel. I'm Lee Price from the FICC Market Structure and Liquidity Strategy Team. In this episode, we're going to focus on a very topical area in capital markets: Private credit. Private credit has become extremely popular with investors in recent years, causing the size of the market to rise rapidly. Today, we'll start out by exploring some of the circumstances behind that growth, and then examine the evolving competitive dynamics and market structure going forward. To discuss these elements, I'm joined by Jake Pollack, Global Head of Credit Financing and Direct Lending at J.P. Morgan. Jake, thanks for being on today.

Jake Pollack: My pleasure. Thanks for having me.

Lee Price: All right, let's kick things off here. In the Market Structure team, we evaluate policy developments and execution trends that impact access to liquidity and if we think about the last 15 years or so, bank regulatory reforms have fundamentally altered the corporate lending landscape. The familiar narrative is that in the years following the global financial crisis, stricter regulatory policies and capital constraints have made bank lending more conservative by necessity. And as a consequence of that, there has been this window of opportunity for alternative investment firms and non-bank lenders, who operated outside the public markets. Jake, we've seen an increasing number of borrowers opt for the private credit delivery mechanism in recent years and while private credit is not a new concept or activity, it has experienced spectacular growth with recent estimates totaling $1.7 trillion in assets under management. From your perspective, what are some of the key factors that have contributed to the exponential growth in private credit?

Jake Pollack: Yeah, so it's a good question. I mean, I think, the larger point I would note is that credit as an asset class has grown tremendously over the last 20, 25 years, and that's both public and private credit. So, if you zoom in on just sub-investment grade corporate credit outstanding, and we go back to, say, 2000, that number was sub a $1 trillion, and the vast majority of that was in high-yield bonds. So, there was really only a $100-or-so million of loans outstanding, and a negligible portion of that was direct lending. Fast-forward to today. There's about $5.3 trillion of sub-investment grade credit outstanding. Whether it's public or private, it's $5.3 trillion of credit. So, as you point out, private credit makes up roughly $1.7 trillion of that number, and it's clearly the largest growth segment. But the first point we have to make is that there's been, like, a five to six-fold increase of sub-investment grade corporate credit outstanding over the past 25 years. The second factor I would highlight is the middle market. So, if we rewind back, again, to the early 2000s, the vast majority of middle market lending was really in the form of bank lending, term loan A's, pro rata deals, to middle market companies that were corporate, and even sometimes family owned. Since then, and particularly over the last decade, PE has made a big push into the middle market, and now it counts for a pretty sizable and growing portion of the ownership of businesses in this space. And so, the PE move deserves a lot of credit as well into the space, because they've created a lot of enterprise value by streamlining operations, rolling up smaller companies, et cetera. And that's effectively created the demand for debt capital that has fueled the direct lending trend that you're noting. So look, yes, regulatory has been a factor. Banks pulling back. That's sort of well-documented. But I think if you zoom out and you look at the growth of credit at large, you see that the middle market PE is what really laid the groundwork, as well as the vast amount of capital that's been raised by the private credit folks who have gained so much scale.

Lee Price: That's right. And if we think about the origins of private credit, starting in small bilateral loans, you mentioned this push into the middle market. And that expansion has really continued with loans being made to larger companies that, today, would have access to the public markets. As a result, private credit is now roughly equivalent to the size of the high-yield market. So, we have an extraordinary amount of capital that has been raised. Obviously, that represents a significant business opportunity. So, it's no surprise that private credit has become a major strategic priority for J.P. Morgan. Jake, you and your team have been building out J.P. Morgan's direct lending program. How's that going so far?

Jake Pollack: The first thing I would say is, at J.P. Morgan, we've been making loans directly to businesses for hundreds of years so it isn't a new concept for us. Private credit came first. Public markets developed after. What is new, and I referenced this a second ago, is the extraordinary amount of capital that's been raised by direct lenders has changed the game in a number of ways. These firms, by the way, are also some of our largest asset manager clients. And so, what's happened is these firms have gotten so big that they are also able to do large transactions directly with borrowers themselves on a bilateral basis, or sometimes with one or two other direct lenders. So in 2021, we set up our direct lending business, and we set it up as a partnership between our markets and our banking businesses, leveraging our best-in-class capabilities of each to enable us to offer borrowers really the best of all worlds. So, we're future proofing our business, right? We're enabling borrowers to decide. If they want to raise money in the public credit markets, they can. If they want to raise money in the private credit market, they can. And so, we earmarked an initial $10 billion of our own balance sheet for direct lending. We've since allocated a good portion of that. And so, we're very much now in the game in direct lending and we aim to allocate substantially more capital going forward, and also to augment that capital with third party co-lenders as well.

Lee Price: Wow, yeah, it sounds very promising. Thanks, Jake. And we've seen this rapid growth, and in both invested capital an in accumulation of dry powder in private credit. A lot of excitement in the space. Sometimes that can foster misconceptions. So, it seems like much of the narrative around private credit has been focused on competition between direct lending firms and banks, but the reality is that many of these firms are also J.P. Morgan clients. And I think that the market evolution here is extremely compelling. We're in this environment where direct lending activity both competes with and compliments the financing solutions being provided by more traditional debt capital markets and credit trading franchises. From your experience leading the private credit financing business, how does J.P. Morgan strike the right balance between partnering with and competing against direct lenders?

Jake Pollack: Yeah, I mean, it's a great question. I think the first thing we have to recognize is that the competitive landscape today is challenging, and it's certainly more complex than it once was. In particular, the lines between competitor and client have blurred and the reality is that in many cases, some of our best clients in one area are also competitors in others, and that's okay, right? That's sort of the state of the market we're in today. I give the example of Netflix and Comcast. In content, they're fierce competitors. NBC and Peacock, which are owned by Comcast, compete for viewers with Netflix. But in the wifi business, Comcast enables Netflix. There's an example of a complex relationship, but one that actually is also symbiotic. And I think most direct lenders who would compete with J.P. Morgan's newer direct lending business also have public markets businesses, which trade with our credit trading desk. They buy new issues of debt from our debt capital markets and syndication desks. They're clients of our CLO franchise, and they're also large borrowers from us in our private credit financing business. So, the new reality can make client relationship conversations more challenging. But frankly, I think once both sides understand the complexities of the market, the focus becomes on how we can partner in areas where we compliment each other, rather just in areas where we're competing.

Lee Price: Yeah, and that's great context. I mean, this mutual beneficial relationships among competitors is something to watch. You mentioned the Netflix and Comcast example. Just because we're recording a podcast, it reminds me of the way you might be listening to a Spotify podcast on your Apple phone. So, I think it's more complex, extremely interesting from a market structure perspective. We've witnessed the entry of alternative liquidity providers in certain fixed income trading markets; the US Treasuries comes to mind that has influenced the execution landscape. And it feels like there are some parallels here in the sense that we have clients that are also competitors. So these lines blurring, as you mentioned. It's an area where I wonder if you can expand on how you're partnering with certain players in private credit today.

Jake Pollack: Yeah. So we talk a lot about our private credit flywheel. So clients of our financing business, oftentimes it might start out with a subline, right? And then moves to an asset-based facility. And then it can move then to a product we call private credit CLOs, right? Where we're actually providing securitization for a client's portfolio. We also syndicate our financing facilities to clients and the syndication partners are often clients that are interested in very high quality exposure to private credit. So these syndications are sometimes unrated to banks or those that need a rating. But when it's to a client that does need a rating like an insurance company, our facilities can be rated between A and up to AAA if we do it in a CLO format. So our financing effectively becomes investment grade private credit which is very attractive, as I mentioned, to insurance and other clients. Many of these clients are also counter parties of our public markets trading businesses and when we connect in one area, we tend to connect and may areas. So I would say our connectivity with clients across the private credit ecosystem tends to lead to a win/win relationship that will grow business for both our clients and for J.P. Morgan in a symbiotic relationship. And it's very exciting.

Lee Price: Yeah, no and it makes a lotta sense. As this market segment continues to evolve seems like we're seeing innovation in the ways to participate. So you mentioned securitization but trading of private credit has gotten a lot of attention lately, although it seems a bit nascent. I'm wondering what you're seeing in terms of secondary market development and private credit. Is there much activity there today?

Jake Pollack: It reminds me a little bit of the saying amongst the nuclear scientist that said cold fusion is 30 years away, and always will be. So the question has come up a lot about private credit trading and when we're gonna see more of it. The market is almost $2 trillion and there has been scant secondary liquidity. First, it does depend on how you define private credit. So I think the definition can expand to sort of when we talk about IG private credit like the recent Intel deal that some private credit folks arranged. I could see those kind of transactions trading with great frequency. When we talk about private credit in terms of, again, sub-investment grade, upper middle market, lower to upper middle market, corporate credit, the players in that space have tended to not wanna see a trade. And it is challenging to create secondary liquidity in a market when the players themselves that only assets aren't looking for liquidity. And look, there's a little bit of a joke that it's pitched as a very high, sharp ratio product. There's almost no volatility 'cause it doesn't trade and the returns have been very strong. So the LPs and the GPs have liked it that way. So that's one point. In times of stress ... And I kinda refer back to the 4th quarter of 2022 was when capital was especially scarce. We did see demand from holders of private credit assets looking for liquidity. So I would expect when we see more volatility again. I think the recent bout was probably too short-lived. But in the next bout of stress we have, I do expect to see more demand for liquidity. And look, as the market grows, it will create more opportunity, but this is still an area where the answer is it's on the come.

Lee Price: That's, Jake. That's very helpful. I didn't anticipate that we'd go into cold fusion on a podcast about private credit-

Jake Pollack:  (laughs)

Lee Price: ... but obviously I'm glad that we did.

Jake Pollack: Yeah. (laughs)

Lee Price: And it's interesting  this illiquidity seems like an important characteristic of private credit. You mentioned the performance of private credit in times of stress. And a little earlier we discussed that in some ways, the stricter regulatory environment for banks help create the original pipeline for non-bank lenders to grow so much. And our team in market structure, we've been tracking that non-bank financial leverage and systemic risk are key focus areas for global policy markers and there have been some concerns, including in a recent feds notes, that private credit contributes to a rise in corporate leverage and that increased competition in private credit markets could lead to a deterioration of lending standards and credit quality. And I wonder if you think these concerns are warranted and what rising corporate default rates would mean for private credit.

Jake Pollack: I think we have to start by acknowledging that the default rate for both public and private credit has been low and our base case expectation is it's going to rise. So the historical default rate in credit has been sort of in the four to five percent range. We've been operating in the two percent range depending how you define it. So the default rate is gonna to pick up, and given how long it stayed in this unnaturally low two percent range, it wouldn't' surprise me if we went a bit above five percent in the next year or two. What would surprise me is if the default rate, again, in the sub-investment grade universe, were meaningfully different than that of the public broadly syndicated sort of B3 market and high yield B3 market over a multi-year period. Certain industries may experience greater defaults than others, but private credit as a whole, in my view, will likely experience a very similar default experience to the public markets and a similar loss, given default. So why? Private credit; you called it a delivery mechanism earlier; and I think that's actually an apt way to say it. Private credit is sometimes written about as if it's some brand new thing like a cryptocurrency or something. It's really just companies that have opted for a bilateral borrower/lender relationship as opposed to a public, syndicated loan. So that choice by the business that's borrowing the money shouldn't have much of an impact on whether that business is able to repay their loan.

Lee Price: That's really helpful. Thanks, Jake. And I guess it leads me to wonder about banks specifically participating in the private credit space. So if you can talk about J.P. Morgan's approach to managing some of these risks.

Jake Pollack: We do as we always do. We've got a very conservative underwriting approach in all our businesses and we take our fortress balance sheet very seriously. So our disciplined approach to underwriting and managing risk is really ingrained in our team's culture. It tends to make us pull back when the market gets frothy and lean in and act as a port in the storm when other lenders are more fearful. So I expect us to continue to operate that way as we increasingly see market volatility.

Lee Price: No, that's helpful and you make an important point about the J.P. Morgan approach, the focus remaining on high quality loans to strong companies. Do you anticipate further efforts to bring transparency to these markets?

Jake Pollack: It's certainly a popular topic and I do think it'll continue to gain traction. Again, especially if we enter a period of greater volatility to the extent that the default rate in credit broadly picks up meaningfully if that creates liquidity issues for funds. Now look, funds can put up gates typically, right? So they tend to prevent it. But, you know, if you've got a situation where a lot of investors would like to basically liquidate their positions and get cash, that has the potential to create a louder voice, right? So I think that's something that bears watching and could lead to a greater push for more transparency in private credit. So we'll have to see.

Lee Price: Definitely. So the global regulatory focus on systemic risk and non-bank financial intermediation will be an area to monitor for sure. Before we wrap up, let's look back into the crystal ball from a markets perspective. I wonder if, perhaps, from what we've discussed, are seeing a convergence between the public and private markets. Whether there is this continued evolution in private credit will mean further product development, sectoral expansion, or perhaps, and we touched on this briefly, a shift towards more bespoke capital raising strategies that incorporate certain private credit elements to them. Jake, where do you see the most attractive investor opportunities in the near future?

Jake Pollack: Yeah, so I think the most attractive opportunities tend to go to investors and investment vehicles with the broadest remits, right? So like those that can enter different market opportunity sets when those opportunities strike. So obviously if you can only buy treasuries, for example, you're limited to opportunities presented by dislocations in the treasury market.  Private credit is an exciting topic because it tends to mean different things to different investors. Direct lenders tend to define private credit, as we've been discussing. Sub-investment grade corporate credit essentially loans to borrowers typically with like a B3 Moody’sequivalent rating. And these loans are originated by, typically, sourcing opportunities directly from sponsored-owned companies. So I expect this market to continue to grow but I think if you expand the lens a little bit there's some other exciting opportunities in areas of private credit. We talked briefly about investment grade private credit. That's one example of a growing space. Infrastructure. There's alternative credit solutions. There's asset-based finance in private credit. I mentioned our financing vehicles, right? We've basically syndicated these vehicles to investors and that's an example of investment grade private credit. So I think these are areas that are still nascent and require creativity and a level of structuring expertise to provide clients with the solutions that meet their needs and meet their LPs needs. So I would say J.P. Morgan is heavily involved in all of these areas and we've created some interesting distribution partnerships with clients that are looking for exposure in these areas. And yeah, I mean, look, we expect these markets to grow significantly over time, so the opportunity set is certainly robust.

Lee Price: Understood. And some great market insights as we try to determine what comes next for private credit. But it sounds like you and your team will be quite busy in the very near future here. Jake, I'd love to continue this discussion but we're about up on time for today's episode. Luckily we've covered a lot, from the growth of private credit, the evolving competitive landscape, the potential risks and regulatory developments, and finally, some investment opportunities. It'll be really exciting to see where this market is headed and how J.P. Morgan participates in the space. Thanks so much for joining today.

Jake Pollack: My pleasure. Thank you for having me.

Lee Price: And to our listeners, thanks for joining us on Market Matters and stay tuned for more FICC market structure and liquidity strategy content on J.P. Morgan's Making Sense podcast. Until next time.

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