Defy volatility with investments in private credit markets
The current volatile market environment is putting pressure on institutional investors. Private credit markets seem to be a welcome alternative, as they offer an attractive return profile and predictable risks. What opportunities does this asset class offer?
While private credit markets were initially focused on providing credit to small and medium-sized enterprises, they have seen strong growth in the recent past. In the last ten years alone, private corporate loans have tripled to more than USD 800 billion1. Since 2008, annual returns have been significantly higher than those on public markets, averaging 9%.
Use private debt in volatile times
In the current volatile market environment, private loans offer a good alternative for borrowers and their sponsors as well as institutional investors. Given the higher execution risk – that is, the potential loss of value from trades due to contract delays – in the broad-based syndicated loan markets, lenders are increasingly turning to the private credit markets. Due to the variable interest rate, these offer a lower interest rate risk along with the chance of a higher return.
The need for secure financing in turbulent times is further underlined by the fact that about two-thirds of the credit volume in the first quarter of 2022 was linked to mergers and acquisitions (M&A) as well as leveraged buyout activities. In addition, the number of defaults remained low last year despite rising inflation, supply-chain bottlenecks, and high interest rates. While an increase in the default rate is expected in the coming quarters, it is likely to affect companies in cyclical industries.
The development of private credit financing
During the coronavirus crisis in 2020, a sharp increase could be seen in the demand for private loans from larger, high-quality borrowers seeking flexibility and security in their financing. It is therefore not surprising that private credit markets have since become a constant in portfolios, even among many institutional investors.
But why has the private credit market developed so strongly in recent years? The global economic crisis in 2007 proved to be a period of high market volatility for the syndicated loan market. In the subsequent economic recovery, this market expanded as larger companies without an investment grade rating looked for ways to meet their need for capital. For smaller companies, however, obtaining this type of financing from low-capital banks was not an option. As a result, private corporate loans developed as an alternative source of financing.
The convergence of private and public debt markets driven by these developments continued with the slump in energy prices in 2015. Energy companies faced declining investor interest. The increasing difficulty in issuing first-lien and second-lien debt securities prompted borrowers and their sponsors to place them with private lenders. From then on, private loans became firmly established, particularly for second-lien and mezzanine financing.
Private debt is likely to remain attractive
In addition, private loans are extremely appealing for both lenders and investors. Compared to syndicated loans, they make it possible to lock in capital and access funds thus allowing private lenders to assess the risk over different cycles. This locked-in capital offers stability because there is no outflow of capital. Furthermore, risk can be priced in during periods of market volatility and periods of borrower-friendly markets. This can be a promising opportunity for institutions such as pension funds and foundations that seek to take advantage of the illiquidity premiums and have a sufficient capital base to tie up capital.
In addition, a smaller group of lenders means better control and a smoother process during underwriting. Better access to due diligence and fast execution are also ensured. Furthermore, funds providing direct loans offer the possibility to negotiate attractive key terms and prices due to the direct relationship between lenders and borrowers.
Given these characteristics and the continued demand from investors for improved return opportunities and stable, rapid capital to complement public markets, the trend toward the convergence of private and public debt markets is likely to be long term and thus further enhance the appeal of the private debt asset class.