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

Aligning Supply and Demand

The current private credit market predominantly serves the middle market. Despite robust demand from the lower middle market, the availability of capital has consistently been restricted. This limitation arises from major asset allocators channeling their investments through managers who struggle to assess and underwrite smaller-scale transactions. Smaller institutional investors, such as family offices and global alternative investment funds, encounter two primary challenges:

1. Identifying high-quality deals suitable for direct or syndicated investments.
2. Balancing a preference for some level of liquidity, even when the underlying investments themselves may inherently lack liquidity.

On the issuer side, there is a notable absence of platforms for accessing private credit. This often forces issuers to rely on high-cost customized deals with high-net-worth investors.

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

Over the recent years, the landscape of DeFi lending has undergone a significant transformation. Initially, we observed the emergence of fully decentralized, overcollateralized crypto lending protocols like Compound and Aave. However, the evolution has progressed to include protocols such as Centrifuge, Goldfinch, Credix, Maple, Huma, and others. These platforms have the capability to facilitate financing for traditional “real-world assets” (RWA) by leveraging DeFi infrastructure.

The spectrum of RWA financing encompasses a diverse range of use cases, including real estate financing, asset-based financing (such as receivables, inventory, and other assets), voluntary carbon offsets, advances (such as pay advance and royalties advance), and receivables factoring, among others. Protocols focusing on these use cases exhibit specialization in specific niches (for example, Goldfinch’s emphasis on lending to fintechs catering to small businesses or Huma’s focus on providing receivables-backed financing to financial institutions) or adopt a geography-focused approach (as seen with Credix offering loans to fintechs and funding receivables factoring in Latin America).

According to RWA.xyz, an on-chain analytics platform for RWA, the private credit market operating on DeFi rails currently stands at approximately $550 million in active loans. Despite being in its early stages, given the substantial size of the global lower middle market, this sector holds immense potential for significant growth in the future.

What Challenges Are Being Addressed by DeFi

Beyond facilitating new capital formation for global trade and commerce, Blockchain offers distinct advantages that are inherent to its nature. Let’s consider the case of Huma and its client, Arf.

Arf is disrupting the conventional practices in the global remittance industry, which traditionally relies on pre-funded accounts (estimated at over $4 trillion) across counterparties to facilitate swift settlements. Leveraging the Huma platform, Arf can extend just-in-time credit to its Financial Institution (FI) clients and promptly settle with counterparties using USDC, a fiat-pegged stablecoin issued by Circle.

In a span of 10 months, Arf has executed over $400 million in settlements using USDC and anticipates reaching an annualized transaction volume exceeding $2 billion in the near future. By liberating capital locked in pre-funded accounts, Arf can significantly alleviate the capital and operational burdens for its clients.

Erbil Karaman, co-founder, and CEO of Huma, remarks, “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.”

Additionally, due to the short-term nature of these receivables, lenders and liquidity providers may access higher liquidity, as evidenced by shorter redemption request periods (e.g., 30-60 days), rather than being bound to illiquid investments for extended periods.

What Lies Ahead

Stablecoins have amassed a market capitalization of around $125 billion. Positioned as programmable money, they are on the verge of becoming the payment and settlement infrastructure for web3, the value internet. However, until there is clarity in US regulations concerning stablecoins, and the passage of a bill akin to H.R. 4766, the broader industry will grapple with uncertainty. Nevertheless, notable companies such as Visa and Paypal are actively venturing into this space. Visa recently expanded its stablecoin settlement capabilities by incorporating Circle’s USDC on the Solana blockchain. Additionally, Paypal, in collaboration with Paxos, announced the launch of its stablecoin, PYUSD, on the Ethereum blockchain.

Despite these advancements, the DeFi private credit industry must address several risk management issues, particularly on a global scale. Recent months have witnessed defaults in private credit deals on well-known platforms, underscoring the importance of robust credit underwriting and ongoing performance monitoring. Over time, these challenges can be either resolved or somewhat mitigated. Various forms of credit enhancements, such as tranching, adding pool covers, or cash collateralization, can introduce layers of principal protection. Anticipated to continue rapid growth in 2024 and beyond, this industry is poised for ongoing expansion.

Sanjay serves as the Vice President of web3 Initiatives at Roofstock onChain, the web3 arm of Roofstock, where he directs the blockchain initiative for the real estate investing platform. He also acts as an Advisor at Pudgy Penguins NFTs and Huma Finance. Leveraging over two decades of finance and product expertise, Sanjay has an extensive history of consulting, developing, and founding various financial companies.

Before assuming his current position at Roofstock, he co-founded and served as the General Manager of Roofstock One, an inventive, transparent rental investment platform enabling accredited investors to access curated SFR properties’ economic exposure. Prior roles include Product Manager at Renew Financial and Director of Carolina Financial Group LLC. Additionally, he co-established LCAP Advisors, offering Wall Street-caliber portfolio analysis and risk assessment solutions to small banks and credit unions for on-balance sheet loans. Sanjay holds a Master’s in Business Administration from The Wharton School.

Roofstock onChain stands as the web3 subsidiary of Roofstock, a prominent digital real estate investing platform focused on the $4 trillion single-family rental home sector. Through blockchain technology, Roofstock onChain empowers investors to seamlessly acquire tokenized single-family rental properties with a single click and conduct transactions using cryptocurrency, streamlining processes compared to traditional systems. Recently securing a $240 million Series E funding round, Roofstock reached a valuation of $1.94 billion.