September 27, 2023
The private debt market has continued to ride a wave of growth this year, despite (or possibly because of) the economic gloom gathering around us.
This asset class has proved resilient thanks mainly to its floating rate exposure, which means investors get paid more as interest rates rise. That provides a valuable hedge against inflation and interest rates and makes it an attractive haven relative to other fixed income assets.
Private credit invests in the debt of non-listed companies and includes mezzanine, distressed debt, special situations, venture debt funds, and direct lending - typically from non-bank lenders to small and medium-sized businesses.
The market has grown steadily for some time but, according to a Bloomberg article, it is now “the hot new thing on Wall Street”, with major recent deals including loans to Zendesk and Baxter International. “In just a few years, private debt has muscled aside banks to become a major source of capital for acquisitions and a popular alternative investment for retirement funds,” said the article.
The market is set to keep firing. Data provider Preqin’s latest forecast shows private debt assets under management growing 10.8% annually from $1.2 trillion in 2021 to $2.3 trillion in 2027. With funds in all alternative assets growing at 9.3%, private debt is also gaining market share.
The private debt market grew out of the global financial crisis as banks started avoiding riskier loans and private lenders filled the vacuum. Post-crisis banking regulations requiring higher capital adequacy made it harder for banks to make money through lending. Specialist private debt managers have been happy to fill the void.
According to Bloomberg, the industry received a demand boost around 2016, when interest rates hit rock bottom and investors were desperate for higher yields. But even now, with rates above 5%, private credit is going strong, it said.
Another supporting supply factor could be the July 2023 banking crisis, after which banks are again tightening lending standards, potentially pushing even more borrowers towards private credit.
Private debt returns have been resilient across market cycles, making the asset class highly attractive as a diversifier.
The Cliffwater Direct Lending Index (CDLI) covers over 13,000 direct middle market loans - the largest segment of the private credit market - totaling $284 billion. In June 2023, the CDLI showed one dollar invested at its inception in September 2004 would now be worth $5.36. Only one of those years was negative - 2008, when returns were -6.50%. The others all posted positive returns of between 5.45% and 15.79%.
Investors’ faith in private debt was well-rewarded by returns in 2022, which remained on the upside during a dreadful year for most other asset classes. The Cliffwater index grew 6.29% last year compared with losses of 19% for the S&P 500, 11% for junk bonds and 1% for leveraged loans.
It’s less volatile too. The index largely comprises senior debt, which is less risky than other types because companies must pay this first if they go out of business. So CDLI has much lower volatility compared to high-yield bond, leveraged loan and share indexes. But its returns are higher than bonds and leveraged loans and on a par with the S&P 500.
Because they tailor loans to each borrower and typically don’t trade the debt, thus locking money up for longer, private lenders charge higher interest rates than banks and public debt markets. This has enabled yields to keep improving - they currently stand at an appealing 11.57% in the CDLI.
Perhaps the most pressing challenge is the potential for increasing corporate defaults as economic pressures continue to weigh on firms’ finances. Floating rates mean indebted companies could face more pressure as interest rates rise. If they can no longer afford interest payments, they may default.
Two consecutive quarters of increasing defaults in the Proskauer Private Credit Default Index, in Q4 2022 and Q1 2023, raised concerns. However, this year’s Q2 figures shows defaults falling back, allaying some of those fears. An article in Private Debt Investor suggested this dip in defaults could be due to proactive companies and lenders using refinancing and other innovative mechanisms to head off issues.
Another cause for reflection is that the number of private debt funds that closed shrank last year. Preqin said this is because investors are “becoming more discerning in their allocations”, making larger commitments to fewer managers. But they remain positive about private debt overall, it said.
An Institutional Investor article highlighted that consultants are also driving institutional allocations to private debt based on a range of benefits.
Private debt’s benefits for institutions include higher yields than traditional investment-grade debt securities; and exposure to a diverse spectrum of risk-return profiles and sectors - from technology to financial, healthcare, and industrials.
According to fund administrator Vistra, economic headwinds and continued stock market volatility keep pushing investors to seek alternative investments that provide some certainty. Traditional equity and fixed income markets haven’t been delivering the desired returns, so diversification into alternatives will persist, with private debt as a focus.
As a result, positive intentions towards private debt continue. As Preqin’s data shows, investors plan to allocate more towards it in the short term, and a healthy 63% intend to over the long term.