After a slight pandemic-era bump, the private credit market has slowed in recent years. Do current economic conditions bode well for the sector?
In the wake of the global financial crisis of 2007-2008, private credit emerged as a reliable source of financing for distressed businesses, non-institutional-grade companies, and borrowers in need of additional junior loans. At the same time, insurance funds, pension funds, and other institutional investors used private credit as a way to diversify and incorporate higher-return investments into their portfolios.
After steady growth over the ensuing decade, private credit reached a high in 2018 in terms of the number of debt financing deals. After that, the market slowed considerably. The economic turmoil of the COVID-19 era caused a sudden need for debt financing, leading to an uptick in deal volume. But since 2022, the market has cooled, as many sectors have.
With inflation easing and interest rates being cut, what can we expect from private credit in future? We will take a look around the industry to see what analysts anticipate for what has become a reliable sector delivering above-average returns for those investors capable of understanding the risk profile involved.
2008-2018: The Growth of Private Credit
The expansion of the private credit market came when it did largely due to a need for lenders. In the aftermath of the global financial crisis, heightened regulations on the banking sector opened up opportunities for private lenders, helped along by a decrease in the number of available bank lenders over the past 25 years. With fewer sources for bank loans and greater scrutiny by banks regarding acceptable risk, businesses deemed too risky by traditional banks looked to private credit, which was not burdened by the same regulatory constraints.
Private credit has offered borrowers alternative sources of capital, more tailored loan products, and fast access to cash in distressed periods. AllianceBernstein stated that “thirty years ago, banks accounted for 75% of US leveraged lending. That figure has since been reversed, with nonbank lenders now commanding a 75% share.”
For investors, private credit (particularly direct lending) has delivered solid returns even in unstable market environments. According to Morgan Stanley, “When measured over seven different periods of high interest rates between the first quarter of 2008 and the third quarter of 2023, direct lending yielded average returns of 11.6%, compared with 5% for leveraged loans and 6.8% for high-yield bonds.”
A Congressional Research Service report on the sector said that “over private credit’s relatively short history, it has generated a lower loss ratio than other comparable debt instruments,” adding that according to a performance review from CalPERS, the country’s largest public pension plan, “private credit was its best-performing private asset segment, with a 13.3% annual return.”
“Investors have increasingly added private credit to their portfolios as a potentially higher-yielding alternative to traditional fixed-income strategies,” says the Morgan Stanley report, which offers additional advantages for investors, including income from interest payments and fees, yield spreads superior to corporate bonds to compensate for illiquidity, and portfolio diversification.
The result was an extended period of growth, with the Congressional Research Service report estimating the size of the global private credit market at “$1.5 trillion to $2.1 trillion in assets under management (AUM).”
After a brief cooling period following the highs of 2018, private credit emerged as a major source of funding for borrowers in need of cash during the pandemic. But since then, the same economic conditions that have affected other markets have also led to a slow period for private credit.
2022-2024: Inflation, Interest Rates, and Recessionary Fears
Following a brief uptick after the lockdown period of 2020, deal volume in private credit steadily decreased from 2021 to 2023. Despite this, returns from private credit have been promising, particularly in direct lending, which Morgan Stanley says “sustained losses of 1.1%, compared with losses of 1.3% for leveraged loans and 2.2% for high-yield bonds” between the outbreak of COVID and 2023. AllianceBernstein concurs that “despite the lower volume, returns for investors in direct lending peaked last year, as the benefit of higher rates and the recoupment of mark-to-market markdowns taken in 2022 more than offset a modest uptick in losses.”
Considering this data, the slump in the private credit market should be viewed not in terms of how it compares to the lengthy period of growth, but by how it compares with other sectors over this recent period. Viewed that way, private credit has held up well. However, with inflation subsiding in 2024 and one interest rate cut already announced, can we expect an upswing? Though data is still forthcoming, here is what we know about 2024 so far.
2024: Private Credit in the Current Market
Preliminary data from 2024 has shown a decline in deal volume from the minor bump of 2023. This may be attributable to a standstill among both borrowers and lenders awaiting the Fed’s announced rate cuts, which were anticipated this summer but did not happen until September. Rate cuts could lead to increased deal volume while still producing high yields for floating-rate loans.
But even though interest rates will be lower, they might not be low enough to greatly increase borrowing activity. The question for private debt managers in 2024-2025, as we see the slow effect of rate cuts and decreasing inflation, is how to find those deals that exhibit value.
As Morgan Stanley says, “a proactive approach has become increasingly important, which includes closely analyzing companies’ earnings and free cash-flow generation in light of the current economic and interest-rate environment.”
For those with expertise in lending to distressed companies, there can be opportunities available in default situations, though they require knowledge to navigate the inherent risks. The upside may not be worth the risk for most investors, especially those not in need of greater high-risk allocation in their portfolios. AllianceBernstein says that for most, “corporate credit will remain the linchpin of their private credit allocations,” advocating that investors “focus on the core middle market, where covenant protections are typically strong. This covers companies with annual earnings before interest, income tax, depreciation and amortization between $10 million and $50 million.”
As for what investors will be looking for in the funds they choose, AllianceBernstein recommends “demonstrated industry expertise over multiple economic cycles” as an important differentiator. “In a market that has grown as rapidly as direct lending has over the past decade and a half, experience and track record among lenders can vary quite a bit. As we see it, the due diligence process is crucial,” adds the report, noting that “how soundly a loan is underwritten is one of the most reliable indicators of performance.”
Alternative Credit Investor took a look at the prospects for investment-grade private credit, which now makes up a significant portion of the market. While noting that “retrenchment by legacy banks” has allowed private credit firms to partner with them on more deals, “which allow them to play to their respective strengths,” the article also stresses that due to macroeconomic conditions, “fund managers and investors seem to be equally concerned with covenant protections at the moment.” The publication points to proper underwriting as the key, saying that “diligent underwriting will be the key to the sector’s long-term success.
One promising area for private debt funds is infrastructure financing, which “more than doubled year-on-year in 2023.” Funds looking for greater diversification may find opportunities in infrastructure deals, as commercial lenders facing regulatory pressures and an aversion to long-term debt may not provide the funding necessary for large-scale infrastructure projects.
According to White & Case, “The flexibility inherent in private debt structures is well suited to support a range of infrastructure financing requirements throughout the lifecycle of an infrastructure asset, allowing managers to offer investors opportunities with varied risk profiles and price points.”
As far as which strategies will see the most action in the near future, the American Investment Council reports that direct lending “continues to be the largest private debt strategy” while also noting that mezzanine debt has consistently outperformed distressed, direct lending, and other strategies.
The Future of Private Credit
While interest rates may lower in the near future, they are unlikely to revert to pre-pandemic lows. This can generate elevated yields for private credit funds but may not bode well for new deals if borrowers choose to avoid high-interest debt. However, there may be additional opportunities for mezzanine debt for companies and projects that have commercial bank lenders but still have holes to fill in a capital stack.
The lack of dealmaking over the past year has left many funds with dry powder ready to deploy when opportunities become available. AllianceBernstein predicts an increase in dealmaking, with “the more recent stability in rates to cause the bid-ask spread between buyers and sellers of middle market companies to tighten, which should increase deal activity.” At the same time, we may see an increase in demand from investors, including retail investors, who are now learning about the historical stability and returns private credit has offered.
Greater fundraising opportunities could lead to more debt financing deals, but as we have seen from the last few years, unexpected market conditions can drastically affect even the most conservative investing strategies. Prudent private credit managers will take advantage of greater borrowing and fundraising demand but will stick to the proven strategies that have gotten them where they are today.
If you’re interested in discussing this article further, please contact Harold directly.
