DeFi Predictions for 2024: Private Credit in the Lower Middle Market

Is web3 alive and well, or is it fizzling out? That seems to be the question on a lot of people’s minds. It’s been a hard couple of years for the global economy at large. In the US, the Fed has taken extraordinary steps to bring inflation under control. It’s also been an incredibly hard couple of years for the crypto industry, exacerbated by large scale collapses stemming from poor risk management all the way to fraud. We are also in an environment of high regulatory uncertainty in the US.

Bleak as it may sound, there is activity in web3 that is showing a lot of promise, particularly in private credit. Let’s do a deep dive.

Historically private credit had focused on mezzanine loans or opportunistic debt opportunities. In recent years, banks have been growing their residential and commercial mortgage books while reducing exposure to commercial loans. While large issuers were able to raise money from bond issuances in the public capital markets, the wide gap in the middle market has been primarily filled by the private credit industry – currently at $1T in the US and about $1.7T globally. High yield corporate debt is currently providing around 9% yield (as of October 2023) and private credit commands an illiquidity premium of 150-300 bps for uni-tranche or senior debt, the spread increasing considerably for junior debt.

Matching Demand and Supply

The existing private credit market mostly caters to the middle market. While demand from the lower middle market has been high, supply of capital has always been constrained. This is because large asset allocators invest capital with managers who are unable to underwrite small-scale deals. Smaller institutional investors like family offices, global alternative investment funds etc., have traditionally faced two challenges:

1. Finding high-quality deals for direct or syndicated investments
2. A preference for some liquidity, though the underlying investments themselves may be fundamentally illiquid.

Issuers, on the other hand, have not had platforms to avail private credit, often having to rely on high-cost bespoke deals with high net-worth investors.

How Decentralized Finance (DeFi) Is Revolutionizing “Lower Middle Market” Private Credit

In the past few years, we have seen DeFi lending evolve from fully decentralized overcollateralized crypto lending protocols like Compound and Aave, to protocols like Centrifuge, Goldfinch, Credix, Maple, Huma and others that are able to finance traditional “real world assets” (RWA) using DeFi rails. The spectrum of RWA financing covers diverse use cases comprising real estate financing, asset-based financing (receivables, inventory, and other assets), voluntary carbon offsets, advances (pay advance and royalties advance), receivables factoring and many others. Protocols focused on these use cases are either specializing in specific niches (e.g., Goldfinch focusing on lending to fintechs that lend to small businesses, or Huma focusing on providing receivables-backed financing to financial institutions), or geography-focused (e.g., Credix offering loans to fintechs or funding receivables factoring in Latin America).

According to RWA.xyz, an on-chain analytics platform for RWA, the private credit market on DeFi rails is currently at about $550M of active loans. While still in nascence, given the size of the global lower middle market, this sector has huge potential for future growth.

What Pain Points Are Being Solved by DeFi

In addition to enabling new capital formation for global trade and commerce, there are specific advantages that are natively possible only on the Blockchain. Let us look at the example of Huma and its client Arf.

Arf is radically transforming the status quo in the global remittance industry which has traditionally relied on pre-funded accounts (estimated at over $4T) across counterparties to enable fast settlements. Using the Huma platform, Arf can provide just in time credit to its Financial Institution (FI) clients and instantaneously settle with counterparties using USDC (fiat pegged stablecoin issued by Circle). Within 10 months, Arf has done over $400M of settlements on USDC and expects to get to $2B+ in annualized transaction volume in the near term. By freeing up capital locked in pre-funded accounts Arf can remove substantial capital and operational overhead for its clients.

Erbil Karaman, co-founder, and CEO of Huma says: “According to the UN, about one in nine people globally rely on funds sent home by migrant workers. What Huma and Arf have achieved shows that remittance companies around the world can now operate with much greater efficiency and instantaneous settlement 24/7 anywhere in the world.”

Also, given the short-term nature of these types of receivables, lenders and liquidity providers might have access to higher liquidity (e.g., 30-60 days redemption requests), rather than being locked into illiquid investments for years.

What’s Next

Stablecoins have achieved about $125B in market capitalization. As programmable money, they are poised to become the payment and settlement rails for web3, the value internet. However, until US regulations on stablecoins are clear, and a bill like H.R. 4766 comes to pass, there will continue to be uncertainty in the broader industry. But we are certainly starting to see major companies like Visa and Paypal getting actively involved in the space. Visa recently expanded stablecoin settlement capabilities with Circle’s USDC on the Solana blockchain, while Paypal, in partnership with Paxos announced the launch of its stablecoin PYUSD, on the Ethereum blockchain.

There are still several issues pertaining to risk management that the DeFi private credit industry needs to solve, especially in a global context. In recent months we have seen private credit deals default on well-known platforms, demonstrating the need for good credit underwriting and ongoing performance monitoring. In time, these issues can either be addressed or somewhat mitigated. Various forms of credit enhancements (e.g., tranching, adding pool covers or cash collateralization) can also create layers of principal protection. I expect this industry to continue growing rapidly in 2024 and beyond.

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Sanjay is the VP of web3 Initiatives of Roofstock onChain, the web3 subsidiary of Roofstock, where he leads the real estate investing platform’s blockchain initiative. Sanjay is also an Advisor at Pudgy Penguins NFTs and Huma Finance. With over 20 years of finance and product experience, Sanjay has an extensive background consulting, developing, and founding several financial companies. Prior to Sanjay’s current role at Roofstock, he was the Co-creator and GM of Roofstock One, an innovative, transparent rental investment platform that allows accredited investors to get targeted exposure to the economics of curated SFR properties. Before joining Roofstock, Sanjay served as a Product Manager at Renew Financial and Director of Carolina Financial Group LLC. He also co-founded LCAP Advisors which provides Wall Street caliber portfolio analysis and risk assessment solutions to small banks and credit unions for their on-balance sheet loans. Sanjay has a Masters in Business Administration from The Wharton School.

Roofstock onChain is the web3 subsidiary of Roofstock, the leading digital real estate investing platform for the $4 trillion single-family rental home sector. Using blockchain technology, Roofstock onChain provides investors the ability to purchase tokenized single family rental properties with one click, and to transact with crypto, cutting the time and cost incurred by legacy systems. Roofstock recently raised $240 million Series E, bringing the company's valuation to $1.94 billion.