The rise of the private debt market has been staggering, especially in the U.S. From humble beginnings, this once esoteric corner of financial markets has grown into one of the juggernauts of the alternative investment universe, with assets swelling from just $44bn at the end of 2000 to an eye-watering $152bn, according to the most recent figures from Preqin.
The trigger for the bulk of this growth was the onset of the global financial crisis, which saw banks drastically reining in their lending to more modest and riskier borrowers in a bid to bolster their own financial health. As a result, a funding gap appeared that non-bank lenders willingly stepped in to fill.
The burgeoning asset class offers a wide range of strategies, catering to all risk appetites and return expectations, and has demonstrated an ability to perform at all points in the credit cycle. Given its appeal, the rapid rise in assets, and the fact traditional lenders are disappearing from the market, private debt has become mainstream within a very short period of time.
What’s more, the asset class has particular appeal to U.S. asset managers, with the strength of the U.S. economy providing a favourable backdrop for private debt. According to the latest government figures, U.S. gross domestic product rose by 3.3% in the final three months of 2023, far exceeding economists’ expectations of 2%. This renewed optimism bodes well for the asset class given returns from private debt are dependent on a company’s success.
In short, an improved U.S. economy should help dampen default risk, while expectations that the Federal Reserve will start cutting interest rates this year on the back of falling inflation, should also mean companies are able to service their debts at cheaper rates. The upshot is investors in private debt funds should face lower default rates.
Strategies
Private debt funds can adopt a number of different strategies but the primary one is direct lending, where non-bank lenders provide credit, usually senior secured debt with a floating rate coupon of up to six per cent above base rate. It is by far the biggest strategy and accounts for almost half of all private debt capital raised.
Other strategies include mezzanine debt, which sits between senior debt and equity in the capital structure and is one of the highest-risk forms of lending, and distressed debt, which involves investments in the existing debt of a financially distressed company.
In more detail, mezzanine debt offers higher returns than direct lending due to its lower seniority and warrants that allow lenders to convert debt to equity. Distressed debt is used to buy into firms trading at a discount to its par value as a result of the company being at or near default or because it is being weighed down by problems with creditworthiness. This may be due to cash flow shortfalls, covenant violations, or because the firm took on too much debt.
And similar to distressed debt, special situations investors target companies that are experiencing difficulties. But unlike distressed debt, special situations investors earmark companies where economic fundamentals are sound but are facing short term issues.
Risks
Private debt has the ability to provide excellent, sector-beating returns but this does not come without risk, and so it is always good for investors to know what those risks are and to make sure they are comfortable with them.
Fund managers also come up against great complexities in this area.
The first one is that returns from private debt are dependent on a company’s success, and so if a firm were to struggle and default on a loan this would negatively impact on the value of the investment. During an economic slump default rates might spike as firms struggle to pay their debts. It is also important to bear in mind that companies relying on private credit may have been previously denied lending by a bank, meaning they have a greater risk of default.
The second significant risk is illiquidity. Private credit is an illiquid asset class compared with other fixed income investment and is only suitable for investors willing to lock their money away for longer periods. If you want or need to sell within a few years it might be difficult — at least without incurring a loss.
Private debt funds pose unique challenges in administration due to the diverse array of portfolio companies managers invest in. Effectively monitoring portfolios requires aggregating company-specific Key Performance Indicators (KPIs) and financial data from various sources, often presented in challenging formats such as PDFs and spreadsheets. Interest calculations add another layer of complexity, varying based on the Limited Partnership Agreement (LPA) and the investment structure, which may include Payment-In-Kind (PIK) or convertible positions. However, advancements in technology, particularly in data transformation and organization, have streamlined these processes. At IQ-EQ, we use technology platforms like Allvue and our Snowflake-based data platform, supported by IQ-EQ Cosmos, to enable seamless access and analysis of critical data, helping to navigate the intricate landscape of private debt administration
A final risk to bear in mind is that the private credit industry may have softer underwriting standards than banks and other traditional lenders but having said that the sector is diligent in underwriting these loans and is very willing to work with borrowers in distress. And important to remember that the U.S. in particular has a regulatory environment that is more homogenous than Europe, for example, making it more borrower friendly.
Rewards
While the risks might be higher than in some other areas of finance, the returns from private credit are eye-catching, with the asset class consistently outperforming. Why? Because private markets are not as efficient as the public markets and so there is a much greater chance for private credit managers to exercise their considerable skill and specialization in uncovering undervalued investments.
Aside from the healthy returns, the sector also provides many other benefits, including protection against interest rate rises and inflation, the provision of fixed payments, handy diversification, and access to unique investments.
More specifically, the diversification benefits arise because private debt is not correlated with the stock market, meaning investment portfolios can become less risky. Importantly, private debt is also diversified from other alternatives by sector, size and the available downside protection.
At the same time, given private debt loans are typically floating rate, they prevent inflation from eating away at investors’ returns, especially when compared to fixed-rate bonds. This has been especially useful in the U.S. where the Federal Reserve has been fighting a long battle with inflation. In a deflationary period, meanwhile, where interest rates fall, rate floors can be incorporated within private debt deals, helping to alleviate the impact of rate drops.
All of this has helped the asset class to thrive, with investors clamouring to get involved. Not only is private debt providing formidable returns, it also offers liquidity at a time where distributions from private equity and other alternative investments have drastically slowed.
The asset class incorporates numerous strategies that suit all risk appetites, return assumptions and liability time horizons. As such the sector has already grown significantly and, with assets predicted to spike to $3.5 trillion by 2028, according to Preqin, the future looks very bright for private debt.
As private debt becomes a more integral part of the alternative investment universe, you need the right supporting partner to fully realize the emerging opportunities. The IQ-EQ U.S. team has an unrivalled combination of experience, global reach and the technological know-how to get the job done. Contact us today.
