Private Debt – An Expected But Uncertain “Golden Moment”?

Since 2008, private credit has not stopped expanding. Yet, banks have reduced their exposure to lending because of regulatory changes, and are not able to satisfy the strong demand from the economy. While the past year’s downturns have shaken markets, companies have continued to require financing and are increasingly turning to private lenders. As a result, private credit is unanimously recognized as a well-positioned asset class. However, recent market data for the last three quarters has indicated the fundraising exercise and the launch of new funds remain very challenging for General Partners (GPs). Such a situation forces market participants to question the private debt position as the most promising asset class for the coming years.

It has not escaped anyone’s notice that the private credit market has been booming during the last fifteen years, going from $280 billion of assets under management in 2007 to $1.5 trillion in 2022, according to PitchBook. It is now fully recognized as one of the primary strategies for alternative investment funds and represents approximately 12% of the global alternatives market. Indeed, private lenders from private credit funds have become references for companies, allowing them to bypass traditional banks when seeking to take out loan facilities. Per Oaktree Capital’s Insights Report issued on May 2021, US banks and securities firms were responsible for over 70% of the loan issuance on the primary market for corporate loans in 1994, compared to 10% in 2020.¹

Believing that rising rates, inflationary pressures, and economic uncertainty offer a few unique advantages for investors, most of the major private equity players have been channelling an increasing share of their assets into the private credit market. Furthermore, there is an estimated $2.72 trillion of global dry powder in private equity, as at September 2023, which points to an optimistic outlook.² In its latest five-year private markets outlook, Preqin forecasts that private credit will nearly double in size reaching $2.8 trillion by the end of 2028, after most investors it surveyed confirmed that they expect to invest even more money in this asset class.³

As a result, private credit is deemed a well-positioned asset class for the present time. Several leaders in the wealth and asset management industry, such as Jonathan Gray, President and CEO of Blackstone and Marc Rowan, Co-Founder and CEO of Apollo Global Management, Inc, have described this time as a “golden moment”⁴ or “great time”⁵ for the private debt market.

Despite these opinions, private debt GPs, like many GPs across all private markets, have faced difficulties in fundraising during the first half of 2023. In accordance with the Private Debt Investor Fundraising report for H1 2023, $84 billion was raised for private debt globally, the lowest total for an equivalent period since 2016.⁶ This trend has continued as confirmed by the updated report, with an aggregate amount raised of $150 billion, trailing behind 2022 and 2021 vintages by $20 and 25 billion respectively. Although North America remains the main destination of private credit capital and has significantly increased its lead during this period, Europe, on the other hand, is severely lagging with only $32.7 billion raised. Fundraising in Europe has declined by 21% compared to Q3 2022. This is mainly explained by the impairment of the economic conditions, the energy crisis and the war between Ukraine and Russia. This trend is also found in Asia-Pacific, Sub-Saharan African, and the Middle East and North African regions, recording an overall decrease estimated at 32%. Finally, while the average fund size has exceeded $1 billion, the number of funds closing dropped from 177 to 150 vehicles closed during the first nine-month period, further confirming the consolidation of the wealth and asset management industry.

Consequently, these recent market reports are questioning whether we will experience a fundraising recovery in the coming months and some asset managers are starting to voice concerns about the reality of this “golden time” of private credit.

The first concern is the sharp increase of the interest rates in a short period of time by the central banks with the objective to fight inflation. Interest rates are at their highest level in the past two decades leading to the increasing number of subordinated strategies in 2023 and the decline of the senior debt issuance. The longer the rates continue to stay high, the more pressure the portfolios of investments will suffer. Furthermore, several old vintage funds launched in a low-rate environment are highly levered and will soon search for a refinancing solution, creating increased stress on the market. Another concern is the likelihood of a credit crunch as banks have already been pulling back on their lending capacity and strengthening their underwriting standards across all commercial and bridge loan categories. While such situation could pose the opportunity for private debt funds to increase their market share, it also adds an additional layer of risk to be taken as the risk profile of most of the corporates has been strongly downgraded. The magnitude of a credit contraction could generate a liquidity crisis, ultimately impacting the performance of the funds. 

The surplus of stress on the investees’ cash flow generation triggered by the compounding of the two concerns mentioned above could lead to defaults and bankruptcies of the investees as well as the funds themselves. Despite the dry powder, US banks are already suffering from low recovery rates and the funds are monitoring their portfolios to identify the investments needed to be impaired. Considering the concentration of the wealth and asset management industry, this scenario could severely impact the entire economy due to the systemic risk created by life insurers that have recently invested massively in private debt funds. This risk is monitored closely by rating agencies such as Moody’s which has created a unit dedicated to the research and rating of the private credit market and has sounded a first warning in last June to two of the leading asset managers for which the interest coverage ratio is at risk. 

The last concern identified by the private lenders comes from regulation changes. In North America, the SEC’s latest rules which are set to strengthen the protection of investors as well as increase transparency and competition in the alternative funds market, require private funds to issue quarterly fee and performance reports, to perform annual audits as well as the disclosure of certain fee structures. A group of asset managers, supported by several other associations including the National Venture Capital Association and the Alternative Investment Management Association, have decided to sue the regulator,⁷ arguing the agency has overstepped its statutory authority. Although the introduction of new regulation is always a challenge for market participants, the latest draft of the Alternative Investment Fund Manager Directive II (AIFMD II), issued by the European Commission, seems to support private debt asset managers as it explicitly allows EU AIFMs to engage in loan origination across all EU Member States. The Directive is expected to be formally adopted in the coming months and the greater flexibility brought to the alternative fund industry should be beneficial to the EU real economy.

Private debt fundraising has shown sign of weakness compared to the prior year, mainly explained by a market-wide reduction in available liquidity. While the above-mentioned concerns could give investors and asset managers an opportunity to pause for thought, the conditions of the markets characterized by the  rise of borrowing costs, the application of stronger and diverse covenants (including the ESG linked) as well as the introduction of new regulation (such as AIFMD II) are ingredients that should be favorable for new deals and performing vintages. Hence asset managers are confident enough to think that the risk of default and bankruptcy can be mitigated through prudent investment selection, disciplined monitoring as well as solid deal structuring. As institutional investors prioritize the need of liquidity rather than committing capital towards private debt funds,  the use of open-ended or semi-liquid vehicles rather than traditional closed-ended funds seems to be a good solution to attract new investors. Evergreen structures could meet the expectations of many Limited Partners (LPs) by allowing them to withdraw money after shorter investment periods or make their investments in perpetuity. It is worth noting that running an evergreen fund is a challenge for GPs due to the requirement for greater transparency around valuation of investments and the management of liquid assets to allow investors to come in and out. However, the demand for this open-ended solution is unprecedented and the creation of new vehicles, such as ELTIF⁸ II, as well as the implementation of new technology, such as tokenization, should bring more flexibility to GPs and give them the opportunity to simplify the access to those funds. Indeed, two of the top asset managers in the US have already integrated tokenization for fundraising, allowing them to broaden their investor bases by reducing the entry ticket size from USD 5 million to USD 20,000. 

As a result, the survey conducted by Preqin on the outlook of the alternative assets for H2 2023 suggests the near future for private debt remains bright. Indeed, a strong majority of the LPs which have participated in the survey indicated private debt is the only private asset class for which most LPs expect returns to improve over the next year and most of the respondents intend to increase their allocations over the longer term. Along with Preqin’s survey’s results, some asset managers are optimistic about the outlook of the private credit market considering that retail investors will get access to those funds, such as Blackrock, which recently predicted that the industry would hit $3 to 5 trillion.⁹

¹Direct Lending: Benefits, Risks and Opportunities, Oaktree Insights, 2021

²Private credit boom continues; pressure builds on Europe's debt market, S&P Global Market Intelligence, 2023

³Future of Alternatives 2028, Preqin, 2023

⁴Private debt is out of control, Financial Times, 2023

⁵Marc Rowan “great times” private credit speech, Financial Times, 2023

⁶Fundraising Report H1 2023, Private Debt Investor, 2023

⁷Private Debit Investor, October 2023

⁸European Long-Term Investment Fund

⁹BlackRock Says Private Debt Will Double to $3.5 Trillion by 2028, Bloomberg, 202