Both AI and persistently high interest rates pose a threat to the private debt industry
Frandeacute;deric Guirinec advises investors to proceed cautiously.
According to Jonathan Gray, president of alternative asset giant Blackstone, private debt experienced a "golden moment" following the sharp increase in interest rates following the pandemic in 2023. Now, the question is whether or not that golden age has passed. Some investors question whether private debt is about to face its first real test as an asset class or even a day of reckoning, given that interest rates are predicted to remain higher for an extended period of time, sovereign yields have risen sharply, and cracks have emerged in US business development companies (BDCs) last summer.
Private debt is a general term. Asset-backed financing, direct lending, syndicated leveraged loans, and even fund financing are all included. They are important distinctions. Although they trade at tighter yield spreads, syndicated loans are liquid and volatile (i.e., they promise lower returns). Direct lending, on the other hand, is illiquid and assets are rarely marked to market when investors, like funds, lend directly to borrowers.
Because direct lending can yield higher risk-adjusted returns, it is frequently positioned as the foundation of "true" private debt. Institutional investors have found it difficult to ignore that record thus far. While reported default rates are still low, spreads of about 550 basis points over base rates are still attractive. Consequently, pension funds and insurers made significant inflows. Preqin, a private-markets data firm, estimates that assets could increase from £1.8 trillion to £2.8 trillion by 2028.
However, some participants and regulators have started to express concerns about the risks of a private-credit crisis due to this capital inflow and its potential to distort industry fundamentals. There have been some indications of stress. Last year, US BDCs gained notoriety due to an increase in investors attempting to redeem their holdings. When redemption requests increase, open-ended funds that invest in illiquid assets may find themselves in a vicious cycle. As funds sell their most liquid assetstypically of higher qualityto satisfy redemptions, the news encourages other investors to do the same in order to avoid becoming the ultimate "bagholders" of the riskiest and less liquid assets. Some BDCs were forced to cap redemptions in order to prevent the "rush for the exits," which clearly does not boost investor sentiment.
Slower growth, ongoing inflation, higher rates for longer periods of time, and a more difficult macroeconomic environment all increase the possibility that the asset class is about to enter a more challenging phase. The fact that valuations are opaque and primarily managed by managers is another issue for investors attempting to comprehend these risks. However, index providers like Bloomberg and S&P are creating private credit benchmarks as the asset class becomes more institutionalized. This, along with BlackRock's 2024 acquisition of Preqin, indicates that private markets will become more standardized and scrutinized, even though some fund managers are opposing this trend.
High interest rates may be preferred by private debt, but borrowers are not.
The main issue at hand, though, is that the same high interest rate environment that attracts investors to private debt is also putting more pressure on borrowers. The likelihood of default is increasing, but recovery rates for private debt have never been accurately calculated. Defaults can be concealed. For instance, the US educational technology company Anthology's restructuring last year did not result in a formal default because its lenders permitted payment flexibility. By postponing payments out of cash flow, payment-in-kind (PIK), which adds interest to the loan principal to be paid at maturity, can also conceal stress. While recovery rates in restructurings may be lower than for senior debt that requires regular cash repayments, the covenant-lite nature of some lending provides less protection than investors might anticipate.
In the meantime, some private-credit vehicles' diversification appears to be weaker than it initially seems. There is a hidden concentration risk because software and/or software-as-a-service (SaaS) companies account for a sizable portion of portfolios. Although these businesses have steady cash flows, recurring revenues, and strong earnings before interest, tax, depreciation, and amortization (Ebitda) margins, there are concerns that artificial intelligence (AI) could seriously jeopardize their business models. AI might not immediately upend these businesses, but it might eventually weaken exit valuations, reduce pricing power, and compress margins, making refinancing more challenging.
Hidden correlation risks in ostensibly diversified portfolios have been brought to light by the sell-off in these software stocks earlier this year and the impact on private debt as investors realize how exposed some lenders are to the industry. The business software company Visma, which has reportedly postponed its planned initial public offering (IPO) until 2027, is now the focus of all lenders. This move may indicate that investors are becoming more cautious despite the company's strong operations and cash generation. This draws attention to yet another significant aspect of the market: the concentration of large credits backed by private equity sponsors. The performance of HgCapital Trust, a specialist private-equity investor in software and services with 13% of its portfolio in Visma, demonstrates how sentiment has changed: it is currently trading at a 25% discount to net asset value (NAV), having been on a premium in 2024. By definition, jitters in private debt can be less visible to the general public.
The market for private debt still has momentum.
Nevertheless, the market is still active. Two significant refinancings of TK Elevator (1.8 billion) and Global Sports Group (2.2 billion) drove strong deal volumes during the first quarter, despite slower M&A activity in Europe. According to Debtwire, "the prominence of these large-cap deals also suggests direct lenders have successfully taken advantage of the volatility seen in Q1 to regain some market share from the syndicated markets." The amount of money raised in 2022-2024 but not yet investedreferred to in the industry as "dry powder"will help the market maintain its momentum.
Direct lending should continue to draw a lot of interest because it can provide a yield that is 100500 basis points higher than what is offered in the traditional syndicated loan market, depending on how much leverage the vehicle uses or whether it acquires junior capital and subordinated debt. Additionally, direct lending can negotiate better structural protections than broadly syndicated loans.
Dry powder will lessen the risk of a private debt crisis by protecting lenders' initial investments and enabling them to inject capital when necessary."refinancing wall"a substantial amount of debt accumulated during the low-rate era that now needs to be rolled over at a substantially higher costwill be addressed with it. Thus far, Liability Management Exercises (LMEs), a euphemistic term for extensions and amendments, have been used to handle this. Widespread defaults are uncommon.
Additionally, we must remember that private debt varies significantly by region. The Trump administration's new regulations have encouraged banks to reenter leveraged finance, making the US market more developed and competitive. Due to structurally lower penetration and a more dispersed banking system, private debt is still growing in Europe. Additionally, keep in mind that private credit is being treated by public markets as a uniform wager on leveraged buyouts. However, managers' skillsorigination, underwriting discipline, and balance-sheet flexibilitywill have a greater impact on results than the asset class itself. A benefit in high-stress situations is scale. Big managers like Ares, Apollo, and Blackstone are able to manage internal restructurings, provide follow-on capital, and modify loans. Because it distinguishes lenders that concentrate on funding commoditized leverage buyouts (LBOs), which are frequently syndicated loans, from those that source bilateral or semi-bilateral deals with better protections and pricing power, origination is the true moat. Securities known as collateralized loan obligations (CLOs), which are backed by a pool of loansoften from LBOshave proven resilient thus far and provide a variety of exposure to leveraged loans. But as the cycle progresses, it may become increasingly clear that they have no control over the underlying loans and, consequently, over the results when borrowers are under pressure.
That "golden moment" is no longer an easy part. Increased rates can be stressful. Returns will be more influenced by selection, discipline, structure, and scale as refinancing pressures increase and dispersion rises than by a rising tide that lifts the entire asset class. A wide opportunity is evolving into a more difficult game.
High minimum commitments are typically required for high-performing private debt funds (e.g., institutional size of 2 million to 5 million to a private debt fund like CVI with strong exposure to central Europe). Individual investors are beginning to be targeted by some managers as a source of additional funding, but one should always be mindful that individuals are less likely to obtain the best opportunities. Steer clear of private bank products where multiple layers of fees build up.
Managers exposed to the industry and listed funds are more intriguing. Fears of a crisis may lead to opportunities to purchase the best ones, but some call for caution. ICG (LSE: ICG), CVC Income & Growth (LSE: CVCG), and Tikehau Capital (Paris: TKO) are European companies with strong exposure to unique circumstances. Blackstone (NYSE: BX) and Ares Management (NYSE: ARES) have created the most robust origination platforms in the United States. Although readers might want to hold off until the dust settles, Apollo Global Management (NYSE: APO) has the strongest exposure to direct lending.
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