New tests on the horizon?
How is private credit faring today and what is the prognosis for tomorrow?
As an industry that largely sprouted from the ruins of the Global Financial Crisis, there are many private credit managers in the market today that have yet to go through a major downturn. The pandemic was clearly a first test of private credit’s resilience, although government intervention to prop up businesses, combined with quantitative easing and low interest rate-setting by central banks, clearly mitigated the worst of the possible effects on private credit portfolios.
A second test emerged last year as inflationary pressures started to hit home last year and the prospect of downturns loomed large. And the industry appears to have weathered this well, too. “For us, 2022 was a fantastic year,” says a private credit firm managing director. “Our margins increased, leverage levels went down and the volumes coming through were strong.”
David Wilmot, Partner at Apera Asset Management, agrees, saying there was a fundamental shift in the deal flow he saw last year. “Volumes have remained consistently strong,” he says. “At the same time, the marginal deals haven’t been coming through the pipeline as they were in the past. The combination of volume and quality means there are good portfolio building conditions out there.”
Meanwhile, a private credit partner at a large multi-asset manager adds: “The syndicated markets went through a nuclear winter and that contributed to the second half of 2022 being the best period I’ve seen. It will be an amazing vintage.”
The rise in interest rates is a positive development in an asset class that largely charges floating rates. Yet the prospects for the coming year may be a little less stellar than we’ve seen in the past six months. Fundraising is one area that looks set to be challenging. This year, for example, Preqin revised down the forecast it had made in 2022 for private debt AUM growth: it was expected to reach $2.69tn by 2026, yet now the anticipated AUM will be $2.3tn by 2027. “Low interest rates had allowed many fund managers to grow fat and happy as institutional investors allocated to private markets,” says the private credit partner. “But inflation and interest rate rises may well act as a brake to the rapid growth we’ve seen over recent times.”
The number of private debt fund managers in the fundraising market nevertheless increased by 18% in the first nine months of 2022, according to Preqin, from 710 to 837. And some may well be disappointed as capital continues to concentrate among larger GPs - the top 10 funds accounted for 50% of aggregate capital raised in the first three quarters of last year – while over a third of managers have been raising for more than two years, Preqin figures suggest. LPs may well be eschewing many of the managers that haven’t navigated more choppy waters before. “Investors are clearly migrating towards well established fund managers with portfolios that have held up over time,” says Neale Broadhead, Partner at CVC Credit Partners.
And the number of managers with these kinds of weather-proof portfolio may well decline as more difficult economic conditions take their toll. “We see some businesses’ gross margins being squeezed – that’s an issue in some sectors and in smaller companies because they can’t bargain with supplier or pass costs on,” says the private credit partner. “No-one foresaw the visceral increase in inflation. That will be a big topic for the industry when we all look back and reflect on our portfolio companies.”
“Some companies will be under pressure as higher interest rates bite,” agrees Wilmot. “The question there will be whether managers have selected the right businesses and protected themselves against cyclicality.”
Yet while there may be some clouds on the horizon, many are predicting an interesting period ahead. And for those targeting larger deals, the market is clearly continuing to expand. “The broadly syndicated market will return at some point,” says the private credit firm managing director. “But the market share of private credit in larger transactions will continue to grow. Private credit, alongside private equity, gives companies permanent access to capital, while syndicated debt markets tend to open and close. Private credit may be more expensive, but it has capital available and is flexible – that’s attractive for many borrowers.”
“We are seeing larger companies tap the private credit market,” agrees Broadhead. “That means we as lenders have more levers to pull, with lower LTV and a wall of equity ahead of you, while also generating double-digit, floating rate returns.”
The private credit partner also sees larger businesses as attractive. “As we pivot away from three decades of deflation, credit selection will come even more to the fore,” he says. “Larger businesses are more resilient than smaller ones – they have bargaining power with their suppliers and their customers, for a start.”
There will also be opportunities in structures that fell out of favour during more liquid times. “It’s a great time to deploy capital solutions,” says Broadhead. “We can fill gaps and create extra layers with structures such as preferred shares and PIK notes. If you don’t need an income return, you can earn high teens returns here.”
“I see some market opportunities for junior capital,” says the private credit partner. “Private equity is pivoting towards value investing. Some of these deals will be hard to lend against and the amount of leverage they can raise will be constrained. We are no longer at a point, like in 2021 and early 2022, when the investment banks could act like distribution machines – they can’t sell risk today like that. So there will be a gap between the syndicated market and equity that junior capita could fill quite nicely.”
So, despite less frothy fundraising and deal markets and a more challenging economic backdrop, private credit players are feeling broadly positive about the next 12 to 24 months. In part, that’s because of the shifting cycle and rising interest rates, but it’s also because of the more structural shift that has been happening for over a decade. “Banks are continuing to recede from the market,” says Wilmot. “Private credit funds are stepping in and our industry is becoming known for being a reliable source of capital – that’s important for sponsors and borrowers, as is knowing who they are dealing with. The asset class has come through some bumps already and has proved its worth – it has remained active through more difficult circumstances.”
Some companies will be under pressure as higher interest rates bite. The question there will be whether managers have selected the right businesses and protected themselves against cyclicality.
As we pivot away from three decades of deflation, credit selection will come even more to the fore,”"Larger businesses are more resilient than smaller ones – they have bargaining power with their suppliers and their customers, for a start.”
