By Justin Partington, Group Head of Fund and Asset Managers, and Joanne McEnteggart, Global Head of Corporate and Loan Servicing
Financial crisis is a normal cycle of the financial markets; it often coincides with increased intervention from regulators using monetary policies to rectify the current imbalance. The current situation of rising inflation and steadily climbing interest rates have helped bring private debt into the mainstream of investment classes as investors seek to avoid the turbulence of public markets. In fact, in every crisis is a silver lining and this is the time for private debt to shine.
Amidst a subdued global fundraising environment, private debt is not merely surviving; it’s thriving. According to predictions from Preqin, private debt assets under management (AUM) are expected to increase at a compound annual growth rate of 10.8%, reaching an all-time high of $2.3tn in 2027. Preqin data also shows private debt to be the only asset class that has grown steadily since 2018, as measured by the value of funds raised. Private debt is even starting to replace a part of the fixed-income element within institutional LP portfolios as it is seen as less volatile and more efficient than the other alternative asset classes.
In this article, we’ll explore the reasons behind the dramatic rise in private debt, identify key growth areas, and speculate on the future of this wildly popular asset class.
Key drivers of growth
The core factors driving the growth of private debt include:
- Hedge against inflation: Against a challenging macroeconomic backdrop, private debt can be seen as a hedge against inflation. Its floating rate exposure provides some comfort to investors, who also benefit from privately negotiated covenants with borrowers
- Financing the maturity wall: Private debt will have a key role to play in refinancing corporate debt that was taken in 2021 and will soon hit a maturity wall. The ‘maturity wall’ is the $1.2 trillion of corporate debt that will have to be paid off or refinanced over the next five years
- Alternative financing option outside of the traditional banking system: Banks are more reluctant than ever to take on higher-risk loans or finance some sectors, making the role of ‘shadow banks’ more essential than ever. We’re also seeing increased collaboration between banks and private debt firms to fund the real economy; both dancing together to the private debt beat
- Greater returns: Lenders are drawn by the significant yield. According to Bloomberg, loans in the private debt market are generally more lucrative than those to ‘safer’ borrowers, with all-in yields of 7-9% compared to the typical ~3% investment-grade corporate bond
- Democratisation of the private markets: Changes in regulations, such as European Long-Term Investment Fund (ELTIF) 2.0 and the UK’s Long-Term Asset Fund (LTAF), are allowing retail investors to access the private markets. As retail investors are searching out new avenues for increased returns, private markets – especially private debt, which tends to be more liquid and less volatile (as it’s easier to put a value on debt than equity, especially in a market where valuations are unpredictable) – are gaining traction
- Private debt favoured for cross-border investments: A recent report from Goldman Sachs shows that managers are more willing to invest abroad into debt than other private market assets in all regions, the U.S. is the next largest debt/ credit Investment market after the domestic market.
Private debt at a glance
- $2.3 tn projected private debt AUM by 2027
- 1075 private debt funds in markets as of September 2023, of an aggregate target size of $ 436.6 billion
- 450 private debt-backed deals completed during January to September 2023
With the challenges in the mainstream lending landscape, we are seeing exponential growth in two areas of the market in particular: net asset value (NAV) financing and commercial real estate (CRE) lending.
The rise of NAV financing
The fund financing space has recently experienced an unprecedented surge fueled by the need for managers to find additional capital. One of its subsets, NAV financing, is fast emerging as an asset class in its own right.
Private equity firms in need of additional working capital for their portfolio companies are turning to NAV financing, which involves borrowing secured against the fund’s equity interest in its portfolio companies. It is typically used once deployment periods are over and the fund doesn’t have capital to draw down from its LPs. This borrowing can influence the internal rate of return (IRR) of a fund as capital is not called from investors immediately and can be returned in advance of proceeds from exits flowing back to the fund.
In a recent interview given to Private Fund CFO, Dane Graham, Managing Director of 17Capital, said that he expects NAV finance to become a $700 billion market by 2030.
Private debt in commercial real estate
Alternative lenders in the CRE debt space also have a wide range of reasons to be optimistic about their prospects over the next 12 to 24 months. Changes in base rates, credit spreads and market structures, combined with enhanced protection via shorter-duration floating rate exposure, have created a favourable environment for non-bank lenders within commercial real estate.
As traditional lenders undergo increased strain from stricter regulations and recent upheaval, the funding gap has opened a door for alternate CRE lenders that is expected to remain open for the next two to three years. In addition, a large amount of CRE debt is maturing soon, allowing alternative lenders to command higher credit spreads. In the U.S., an estimated $450-500bn will mature annually from 2023 to 2026. In the UK and Europe, over €390bn will mature in 2023 alone.
With property valuations in a general decline, CRE lenders can negotiate better terms while taking advantage of the tailwinds bolstering the market. Regulations that have driven traditional banks toward more conservative behaviour have driven demand, creating significant opportunities in markets where private debt is still a small part of the financial services landscape.
Growth trends and forecast
In addition to the anticipated growth of NAV financing, private debt is actively growing in a number of areas:
- Investor interest: A H1 2023 Preqin survey found a bullish sentiment among investors, with a substantial rise in investors’ intentions to increase their allocations to private debt over the longer term, up from 47% in 2021 to 63% in 2022. Preqin expects this to translate to a strong fundraising market throughout 2023
- S. growth: North America is by far the largest geography for private debt by AUM, predicted to reach $1.4tn by 2027
- Potential in Asia: APAC has a larger count of funds than one might expect based on capital raised. To date, four APAC private debt funds have closed above the $500 million mark
- Large fund managers: Consolidation is evident across all asset classes, but it’s even more pronounced in private debt. Some notable deals taking place this year include First Sentier Investorsacquiring a majority stake in European credit specialist AlbaCore Capital Group in March. In January, Brookfield Asset Management acquired DWS Group, the secondaries unit of Deutsche Bank
Technology as an enabler
Private debt is arguably the most complex asset class requiring specialist administration and reporting with various cashflows and covenants to track. The emergence of new technology in that space is allowing the automation of the whole loan administration process including loan calculation. Specialised technology providers such as Allvue are further enabling the democratisation of the sector, together with the changes in regulations as mentioned before.
What lies ahead for private debt?
Investors continue to favour private debt, valuing its diversification opportunities and steady income stream. By 2027, predictions indicate that this asset class could easily command $2.3tn in AUM. As demonstrated by a recent Goldman Sachs article, even if private debt is growing, it still represents a small share of total private capital allocations; with the exception of dedicated alternative fund managers, private debt weights are <5% across investors. This means higher growth potential. With global growth in a lull, upheavals rocking the banking world and geopolitical tensions, private debt is emerging as a silver lining to investors in search of substantial returns and a measure of predictability.