By Justin Partington and Ilias Georgopoulos
The Global Financial Crisis changed everything. Interest rates plummeted to historically low levels and stringent regulations on how banks can lend from their balance sheets were put in place. This retrenchment of lenders left a vacuum in the market for providing financing for private equity-backed deals. Enterprising asset managers stepped in, providing private capital with a long-term outlook and a risk appetite that went beyond that of balance sheet investors.
Private debt, the asset class that emerged, is today the hottest sector in alternative investments, if not the entire investment universe. This article explores how we got where we are today, why investors are clamouring to put their money in private debt and what the future might hold for the space.
From humble beginnings…
Private debt, a catch-all term for non-bank lending, began in the 1980s with companies borrowing directly from insurance companies. It remained an esoteric corner of the financial universe until the Global Financial Crisis of 2008 saw the risk appetite of banks evaporate overnight and subsequent regulation curtailed lending activity. In stepped opportunistic asset managers, and in the intervening years private debt has grown to a $1.6 trillion industry and a viable alternative to mainstream lending.
Private debt financing can accommodate a wide range of borrowers and has several benefits compared to using more traditional credit providers. Direct lending, historically the most prevalent form of private debt, involves non-bank lenders acting alone or in a small group to extend credit to mid-market, often private equity-backed, businesses. These loans can vary in structure, but are typically senior secured, have a floating-rate coupon and are held to maturity by lenders.
The growth in direct lending is a result of banks pulling back from lending to these types of businesses. In Europe, the ratio of LBO deals financed via direct lending to those financed by broadly syndicated loans was 2.0x in Q1 2020, whereas in Q2 2023 this was 4.7x, according to LCD. Alongside availability, factors such as speed, certainty, convenience and confidentiality are features of direct lending and are highly attractive to borrowers. Additionally, private debt lenders will often have sleeves of capital with different risk appetites, meaning they can structure debt packages across the capital structure, providing both senior and junior debt as part of the same deal. This unitranche lending means borrowers can deal with one lender for an entire refinancing and benefit from the speed and administrative simplicity this offers.
…To a must-have asset class
Private debt fundraising has grown by more than 5x since the GFC, rising from just $44bn in 2010 to $152bn in the first three quarters of 2023, with Investor appetite fuelled by the global macroeconomic environment. Historically low interest rates saw yields for fixed income investments dry up, and the returns premium available for holding illiquid loans, up to 300 basis points, made the asset class attractive. As managers built a track record and weathered turbulence including the European sovereign debt crisis and Covid-19 disruption, institutional investors with a more conservative risk appetite began looking at private debt.
For these institutions, the opportunity that direct lending presents to invest in the senior secured debt of small- to large-cap private companies, with the varying risk profiles factored into the pricing of the loans, is a compelling one. Not only is the asset class providing outstanding returns, it also provides liquidity at a time where distributions from private equity and other alternative investments have slowed to a trickle. Institutional investors such as pension funds and insurance companies are increasingly looking at private debt due to its cash flows providing a good match to their long-term liabilities. Increased fundraising resulting from this has meant that direct lending funds can match large banks and finance larger deals. In August 2023, a consortium of lenders provided an industry record $4.8bn loan to fintech company Finastra.
The challenging environment of the last couple of years, with war in Europe, inflation and interest rates rising, supply chain issues and the energy crisis, has seen significant volatility in other asset classes but has not dampened investor appetite for private debt. Private Debt Investor’s H1 2023 Investor Report saw 60% of insurance companies and 43% of pension funds increasing private debt allocations, and a Preqin survey of institutional investors in November 2023 found that more than 50% planned to increase their allocation to the asset class over the long term. Investors looking for a safe haven from interest rate hikes and rising inflation are turning to private debt, which is insulated from these by the floating rates its loans are typically priced on.
Real estate private debt has seen growth driven by similar factors. Private lenders are stepping in where banks are retreating to offer competitively priced debt across the capital structure. Investors anticipate that the post-pandemic upheaval, particularly in the commercial office space, will offer managers a wealth of opportunity and managers are gearing up to take advantage of this demand. Preqin tracked 51 real estate debt fund launches in 2023, three times the number of funds launched during the previous year.
Interest rates and inflation have also seen an uptick in returns from direct lending. In November 2023, the head of private debt at a Swedish pension fund stated in an interview that senior loans in the U.S. were yielding 12%, and that this level of returns meant that private debt, even the lowest level on the risk spectrum, could be viewed as a good alternative to equities.
For investors with a higher risk appetite, the private debt market offers a range of strategies to suit all preferences. Venture debt lends to high-growth start-ups backed by venture capital that are often loss-making. Mezzanine finance sits between debt and equity in the capital structure, offering higher returns to compensate for the increased risk of being lower in the queue to be repaid should a borrower be unable to meet their obligations. This type of investment saw a surge in investor appetite in 2023, with $40.6bn raised for the strategy in the first three quarters of the year, accounting for 27% of all private debt fundraising, according to Preqin. Investors see the strategy as a strong play at this point in the credit cycle. As cheap senior credit becomes scarcer due to lenders adopting a more risk-averse approach, borrower demand for mezzanine debt is likely to increase.
Other private debt strategies poised to make hay as the credit cycle progresses include special situations and distressed debt. Special situations lending describes loans extended where a particular event or situation means lending decisions are independent of a company’s financial health. Distressed debt describes private debt funds buying up company debt trading at well below its original value with the aim of generating returns when the company restructures or liquidates and distressed debt funds accounted for 11% of all private debt capital raised in the nine months to the end of Q3 2023. These more niche credit strategies are seeing a rise in investor interest, with Preqin reporting that 51% of LPs surveyed saw distressed debt as among the best opportunities in private debt, and separately forecasting distressed debt IRR to grow to 14% from 2022-2028, up from 6% between 2019-2022.
Marc Rowan, CEO of private credit pioneers Apollo Global Management, said on an earnings call last year that, “This is not a quarter that’s a great time for private credit, this is a secular change… We are in the beginning of a secular shift in how credit is provided to businesses.” If private debt fundraising is anything to go by, institutional investors seem to agree. The asset class incorporates a huge range of strategies to suit all risk appetites, returns expectations and liability timeframes, and can perform at all points in the credit cycle. Given the wealth of opportunities on offer for investors and the regulatory pressures forcing other lenders out of the market, private debt is poised to become the dominant asset class in alternative investments over the next decade.
Private debt, also known as non-bank lending, is an asset class that emerged in the 1980s but gained significant traction after the Global Financial Crisis (GFC) in 2008. During the GFC, the risk appetite of banks diminished, leading to a decrease in lending activity. This created an opportunity for opportunistic asset managers to step in and provide financing for private equity-backed deals. Since then, private debt has grown into a $1.6 trillion industry and has become one of the hottest sectors in alternative investments [].
Private debt financing offers several benefits compared to traditional credit providers. Direct lending, which is the most prevalent form of private debt, involves non-bank lenders extending credit to mid-market businesses, often backed by private equity. These loans are typically senior secured, have a floating-rate coupon, and are held to maturity by lenders. Direct lending has grown as banks have pulled back from lending to these types of businesses [].
The growth of private debt fundraising has been significant since the GFC. In 2010, private debt fundraising was just $44 billion, but it rose to $152 billion in the first three quarters of 2023. This growth can be attributed to historically low interest rates, which reduced yields for fixed income investments, making private debt an attractive option. Additionally, private debt provides liquidity at a time when distributions from private equity and other alternative investments have slowed down. Institutional investors, such as pension funds and insurance companies, are increasingly looking at private debt due to its cash flows aligning well with their long-term liabilities [].
Real estate private debt has also seen growth driven by similar factors. Private lenders are stepping in where banks are retreating to offer competitively priced debt across the capital structure. The post-pandemic upheaval, particularly in the commercial office space, is expected to provide opportunities for managers in this sector [].
Private debt offers a range of strategies to suit different risk appetites. Venture debt, for example, provides financing to high-growth start-ups backed by venture capital. Mezzanine finance sits between debt and equity in the capital structure and offers higher returns to compensate for increased risk. Other strategies include special situations lending and distressed debt. Special situations lending involves loans extended in unique circumstances, while distressed debt involves buying company debt trading at well below its original value. These niche credit strategies are seeing a rise in investor interest [].
Private debt has delivered attractive returns, especially in the current environment of low interest rates and inflation. Senior loans in the U.S. were yielding 12% in November 2023, making private debt an appealing alternative to equities. The asset class has performed well across different points in the credit cycle, making it an attractive option for institutional investors [].
In conclusion, private debt has become a dominant asset class in alternative investments since the GFC. It offers a wide range of strategies, accommodates different risk appetites, and provides liquidity. With regulatory pressures forcing other lenders out of the market and a wealth of opportunities available, private debt is expected to continue its growth and become even more prominent in the next decade [].
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