The Rise and Resilience of Private Debt
Private debt (or credit) has increasingly become a key component in private equity dealmaking. Private debt funds encompass a range of approaches, from providing companies with direct loans to purchasing distressed debt. As an investment strategy, private credit, and particularly direct lending, experienced incredible growth over the past 10 years in tandem with private equity investing, which exploded into a trillion-dollar deal market of primarily middle-market companies. According to Preqin, private credit funds raised a record-breaking $193 billion globally in 2021, up 13% from $169 billion in 2020.
In the context of this tremendous growth, current market uncertainty created by macroeconomic and geopolitical factors may be the first major test of private credit’s resilience. Credit fund managers’ response to business threats caused by lockdowns during the early days of the pandemic gives us an idea of how they will adapt to any future challenges faced by portfolio companies. As in the past, credit fund managers relied on strong partnerships with private equity investors to work together to reduce portfolio company defaults and seek new lending opportunities. As financial intermediaries at the center of this competitive asset class, private credit managers can be expected to continue to adapt to private equity and broader credit market dynamics.
Favorable demand and supply dynamics
During the past decade, alternative assets have grown at an unprecedented pace, reaching $13.3 trillion in assets under management (AUM) in 2021 (see Exhibit 1). Private credit rode this wave, rising to $1.2 trillion the same year. As one of the fastest-growing asset classes, credit is expected to hit $2.69 trillion in AUM by 2026 and overtake real estate as the second-largest private capital asset class after private equity.
Exhibit 1: Private Debt’s Growth Relative to All Private Assets, Global AUM
Source: Preqin and First Republic Analysis.
Fueling private credit’s robust growth is an expanding opportunity set of private equity–supported middle-market companies and a growing pool of yield-hungry institutional investors looking to match their long-term assets with investment of similar longevity.
Growing demand for direct lending
Private credit in its simplest form involves non-bank institutions providing non-traded loans to private companies based on their cash flows. This form is often referred to as “direct lending.” Direct lending funds represented approximately 58% of capital raised globally (a record $112 billion) by credit funds closed during 2021. Private credit’s impressive standing should be little surprise to private equity firms because the two fund types work hand in hand. As private equity funds have purchased a growing number of middle-market companies, their greater deal activity required more direct lending. In 2005, private credit composed about 7% of roughly $1.4 trillion below investment-grade financing in the United States, and it has grown to about 22% of this $3.7 trillion market at the end of 2021.
Lower- and middle-market companies are the largest borrowers of private credit. As they tend to be smaller companies (averaging $30 million EBITDA) and often highly leveraged, most of these companies are unrated and thus experience constraints when accessing larger and more liquid credit markets. Another unique distinction of private credit and a key source for its growth is that a significant share of borrowers is backed by equity from private fund sponsors. Consequently, the typical loan term to a sponsor-backed company will match the three- to six-year investment period that the private equity sponsor will use to actively improve and grow the company’s operations.
However, credit funds can also provide direct loans to companies outside of sponsor acquisitions. In many instances, companies may be pinched for working capital or need additional funding for growth, and they turn to private credit funds for flexible financing. In this way, credit funds can support buyout acquisitions or customized company needs.
Unlike loans traded in broadly syndicated markets, direct loans come with illiquidity risks. However, holding a company’s debt to maturity creates incentives for private credit managers to gain a “partnership mindset” with the company. As a result, credit managers are active in identifying and mitigating risks. For instance, private credit lenders are uniquely positioned to address problem loans by their ability to take equity and make additional loans in distressed situations. The law firm Proskauer estimates that private credit default rates compare favorably to syndicated institutional loans, with the former showing equal or lower default rates during Q2 2020–Q1 2021. Private credit funds maintain an advantage as counter-cyclical capital that can be critical in stabilizing companies during dislocations.
In the highly competitive world of leveraged buyouts, private equity sponsors demand partners that can move fast and provide price certainty and confidentiality around financing, but also have the flexibility to provide more leverage to meet unexpected needs. The interdependence between equity and credit providers in these deals has created a shared mindset on the importance of building strong long-term relationships between private equity and credit fund managers. In fact, many successful large private equity firms — such as Apollo, KKR and Blackstone — as well as middle-market firms — such as Francisco Partners, Silver Lake and Gryphon Investments — have taken the step of creating private credit teams at their firms. By adding lending to the platform strategy, the firm can invest up and down the capital structure, but not necessarily in the same deals.
An abundant supply of investor capital
Consistent with other private investment strategies, private debt funds have experienced strong fundraising during the pandemic. In 2021, $193.4 billion was raised, a 14% increase from the year before, according to Preqin. Direct lending funds raised almost $125 billion in 2021 — the most capital among the private debt types (direct lending, distressed and mezzanine). Average fund size grew substantially to $958 million in 2021 from $663 million in 2020, indicating the capacity for managers to write larger checks and the greater demand for credit in private acquisitions.
The historically low interest rate environment has benefited private credit fundraising as investors turn away from traditional fixed-income products to seek higher yields from private credit funds. The advantage of investing in private debt is steady fixed-income returns with typically higher yields than publicly traded bonds. Direct lending has historically offered investors stable returns of almost 9% (see Exhibit 2). In addition, investors gain exposure to a larger and more diversified universe of companies than in the public market. Using Capital IQ data, Hamilton Lane estimates there are over 17,000 private companies with $100 million in annual revenues, compared to only 2,600 public companies of the same size. Investing in private company debt can thus help provide greater diversification to institutional portfolios.
Exhibit 2: Asset Class Yields
Source: JPMorgan and Preqin.
The positive attributes associated with private credit are driving the demand by institutional investors to allocate to this strategy. The gap between actual allocation (3.0%) and target allocation (5.7%) in private credit by U.S. state and local retirement funds is the widest than in any other alternative investment strategy (see Exhibit 3). At the same time, public pensions have decreased their allocation to public U.S. bonds from 36% in 2001 to 20% in 2021, according to Wilshire Trust Universe Comparison Service.
Exhibit 3: U.S. Public Pension Allocations, Actual and Target
Source: Wall Street Journal and Preqin.
Market tests of resilience
The highly favorable credit conditions enabled by ultra-low interest rates that helped to power these markets may be coming to an end. The Federal Reserve and other global monetary authorities have already begun tightening monetary policy, and the Federal Reserve announced additional rate hikes totaling 75 to 100 basis points in 2022. While the spread in yield between private credit and public credit may have initially fueled investors’ demand for it, private credit is now a strategic component of portfolio diversification. Changes in interest rates likely won’t alter institutional investors’ private credit allocation targets.
The bigger monetary concern is that rate hikes might trigger an economic slowdown. Unlike private equity funds, few of today’s private credit managers have been tested by a severe downturn. Most credit firms got their start after the Global Financial Crisis in 2008. However, the early days of the pandemic may assuage concerns about these managers. In spring 2020, when most of the country went under lockdown, lenders and private equity sponsors worked closely with portfolio companies’ businesses to help them maintain liquidity and adhere to lending agreements.
It is expected that the demand for direct lending will continue. Private equity funds acquiring lower- and middle-market companies creates a large and growing need for credit, and these funds have ample dry powder for new deals after record fundraising in 2021. In fact, volatility in public markets may ease pricing pressure in private markets, making acquisitions more attractive, increasing deal activity and generating more opportunities for private credit funds.
Together these attributes put private credit, like private equity, in a strong position to weather a more volatile environment of rising rates and uncertain markets. Equally as important, private credit funds’ investment vehicle structure, like with private equity funds, has the capacity to provide flexible, long-term capital when it is likely to be the scarcest — and at the same time generate steady income for investors.
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