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.
Stellar returns
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.
Conclusion
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.
As a seasoned expert in alternative investments, particularly in the realm of private debt, I have been closely tracking the evolution of this asset class and its transformative impact on the financial landscape. My in-depth knowledge stems from years of hands-on experience, closely monitoring market dynamics, and analyzing key trends.
The article penned by Justin Partington and Ilias Georgopoulos delves into the fascinating journey of private debt, tracing its roots back to the aftermath of the Global Financial Crisis (GFC). The GFC reshaped the financial terrain, ushering in historically low interest rates and imposing stringent regulations on traditional banking practices. This upheaval created a void in the financing ecosystem, which astute asset managers promptly filled by providing private capital with a distinctive long-term outlook and a risk appetite that surpassed traditional balance sheet investors.
Private debt, now a $1.6 trillion industry, emerged as a versatile asset class with the capacity to cater to a broad spectrum of borrowers. The term encompasses non-bank lending practices that gained traction in the 1980s, initially with companies borrowing directly from insurance companies. However, it was the GFC that propelled private debt into the mainstream, as risk-averse banks retreated, opening up opportunities for opportunistic asset managers.
Direct lending, a predominant form of private debt, involves non-bank lenders extending credit to mid-market businesses, often backed by private equity. This approach gained momentum as banks scaled back from such lending activities, with Europe witnessing a significant shift in the financing landscape. Direct lending's appeal lies in its speed, certainty, convenience, and confidentiality, attracting borrowers seeking alternatives to traditional credit providers.
The growth in private debt fundraising has been staggering, increasing over fivefold since the GFC. The macroeconomic environment, characterized by historically low interest rates and a dearth of yields in fixed income investments, fueled investor appetite for the asset class. Institutional investors, including pension funds and insurance companies, found private debt particularly enticing due to its ability to provide both outstanding returns and liquidity, especially when distributions from other alternative investments slowed down.
Real estate private debt, driven by similar factors, experienced notable growth as private lenders filled the void left by retreating banks. The upheavals of the last couple of years, including the European conflict, inflation, supply chain disruptions, and the energy crisis, did not dampen investor interest in private debt. In fact, the asset class gained traction as a safe haven from interest rate hikes and rising inflation.
Returns from direct lending saw an uptick, with senior loans in the U.S. yielding an impressive 12%. For investors with varying risk appetites, the private debt market offers diverse strategies, including venture debt, mezzanine finance, special situations, and distressed debt. These strategies cater to different preferences and risk profiles, contributing to the resilience and attractiveness of private debt throughout different points in the credit cycle.
The article concludes with a quote from Marc Rowan, CEO of Apollo Global Management, emphasizing that the shift towards private credit is not a short-term trend but a secular change. This sentiment is echoed by the surge in private debt fundraising, indicating institutional investors' confidence in the asset class. As regulatory pressures continue to reshape the financial landscape, private debt is poised to emerge as the dominant asset class in alternative investments over the next decade.
In summary, the article comprehensively explores the origins, growth, and appeal of private debt, painting a compelling picture of its transformative role in the post-GFC financial landscape.
