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Recent actions by the Fed and the European Central Bank to decrease interest rates have brought some relief and hope to the markets. While private credit has good reasons to rejoice, concerns are also rising about the future performance of this asset class.
Resilience in changing macroeconomic environment
Over the past five years, the private asset market had to navigate several challenges in an ever-evolving macroeconomic environment. The pandemic, interest hikes and transaction scarcity had their fair share in the list. In this context, private credit emerged as a resilient asset class. Filling the financing gap left by the retrenchment of banks, the asset class consolidated its position as a reliable source of capital in the full spectrum of credit strategies and became one of the preferred allocations for investors. According to Financing the Economy 2024, Private Credit now represents more than USD 3 trillion assets under management worldwide.
Six years of financing growth despite severe economic and political challenges (USD billion capital deployment by Financing the Economy survey participants)
Source: AIMA-ACC & EY Financing the Economy 2024
A recent decrease in interest rates arrived after a persisting period of high rates which profoundly affected the industry. Even though high rates were not the sole driver boosting the attractiveness of the asset class in recent years – increased investors’ familiarity and more favorable regulations also helped – concerns are rising.
Revival of dealmaking
Macroeconomic stability and regulatory certainty are expected to boost transactions in 2025. In a context of high levels of dry powder, the revival of leveraged buyouts should be significant and that is good news for credit funds which never really stopped fundraising. 2024 private credit fundraising is expected to land at a higher level than the prior year, after the 2021 record year close to USD 350 billion raised.1 Consequently, capital deployments are expected to flood the market in the coming years.
Financial models put to the test of the real economy
Concerns are rising on upcoming performance. The double effect of, on one hand, new originations at lower spread and, on the other hand, the backlash of the mechanisms put in place during high rates period to relieve borrowers, might affect yields on overall portfolios in the future. Indeed, maturity extension, shift to payment-in-kind interest and waiver of covenant breach were extensively applied while borrowers were struggling to manage their interest coverage ratios. Agencies who tried to develop default rates showed that they have remained at relatively low levels despite tense market circumstances since 2020. Data might however hide some bias in asset valuations, especially now that rates are turning down. Values of the past high-yield originated loans might benefit from an uptick when rates are decreasing and may not fully capture the distressed reality of borrowers if credit risk is not accurately adjusted. We might then face a situation where financial data is deviating from real economy.
Source: MSCI data presented by Private Debt Investor
Conclusion
The revival of dealmaking is a positive sign for the alternative investment industry, but challenges remain. Private credit players will have to keep an eye on borrowers, especially the most vulnerable ones to test their models in time of turmoil. No doubt that such a resilient asset class will find its own way to navigate this new macroeconomic environment.
To read the complete Financing the Economy report, visit our website.
Summary
Recent rate cuts by the Fed and ECB have boosted optimism for private credit markets, which have shown resilience amid macroeconomic challenges like the pandemic and interest hikes. While private credit is poised for growth, with increased fundraising and dealmaking expected in 2025, concerns linger about future performance as lower spreads and mechanisms to aid borrowers during high-rate periods may impact yields. Despite these challenges, private credit remains a key player in the financing landscape, supported by investor confidence and its adaptability.
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