Private credit: a broad range of investment solutions for fresh capital providers
While there was already investor interest and appetite for private debt before the 2008 financial crisis, banking regulations that followed it, such as the Dodd-Frank Wall Street Reform and Protection Act and Basel III, served as a catalyst of demand for financing opportunities from non-bank lenders.
The investment landscape may be changing rapidly, but the need to generate results will persist. In this environment, private and alternative credit offer investors higher yield potential at lower risk, relative to public corporate bonds. These types of debt also expose investors to economic drivers that are generally not present in public credit markets, which can result in significant diversification benefits.
As such, private lenders can cover the spectrum of risk-return and duration characteristics. Given the variety of roles the different areas of private credit can play in investors’ portfolios, we expect the growth of private credit to continue.
Covid – no escape
As has been the case for many businesses, economies and assets, the Covid pandemic hit private credit markets particularly hard. After an initial shock that drove valuations down dramatically, the sector was revived by massive monetary policy responses from central banks. The period ahead will likely prove complex, as whatever long-term effects of such pandemic measures play out on both individual companies and the global economy. The likelihood of increased funding needs is high and will offer a large array of opportunities. Even if the level of restructuring and potential distress reach a similar scale to the post-2008 default wave, the coming private credit cycle is expected to be significantly different than the one that followed the 2008 crisis due to a number of factors.
First, structural changes in credit markets over the last 10 years set the scene for a broader but more organised investment market. As an example, looking at how the composition of the real-estate mortgage market has evolved offers insight on the shift that occurred in debt holdings. In 2007 commercial mortgage-backed securities (CMBS) composed north of 65% of the market; at the end of 2019, its market share had decreased to 20% (see chart). In its place was a variety of different players, from local banks to the ever growing private-debt funds.
These impacts will also be felt across a credit market that is far larger than it was at the time of the 2008 financial crisis. According to Blackrock, sub-investment grade debt has increased nearly 300% to about USD 5.6 trillion in 2021, versus about USD 2 trillion in 2007. At a company level, leverage has also increased. According to LCD Research, the debt/EBITDA ratio or leveraged buyout acquisitions increased to 5.9x in 2021, its highest level since 2007. This increased level of financing, coupled with an uncertain economic recovery and the increasingly covenant-lite number of structurings, will complexify resolution. As a result of central banks’ monetary policy responses and the lower cost of capital, many companies and landlords have been able to issue affordable debt to withstand the downturn. We believe that this is only a short-term phenomenon that will result in a wave of difficult future refinancings.
The amount of capital that will be needed in the post-pandemic environment is expected to be significant, and to meaningfully exceed the dry powder available to alternative lenders. In 2020, private debt fundraising was surprisingly stable in the most mature region (+2.4% year-over-year in the US), and is a testament to a growing investor base that is still looking to deploy assets into high-yielding opportunities.
The investment opportunities offered by credit markets are expected to be significant in both scale and returns over the coming years. However, complexity and sector dispersion will test investors’ ability to take advantage of current and future dislocations, tap into the distressed markets and build flexible and nimble private credit allocations.