What is fuelling the surge in private debt?

Private debt is one of the world’s fastest growing alternative asset classes. Over the past decade, the market has grown 13.5% on average annually, with assets under management (AUM) hitting $1.2 trillion at the end of last year, according to Preqin. The same report notes that this represents the second quickest pace of growth of all private market asset classes, behind only infrastructure.

Aggregate fundraising hit a record $192 billion across all private debt fund strategies last year, 10% more than in 2020 and almost five times more than was raised a decade ago, according to McKinsey. The research goes on to mention that limited partner (LP) allocations to private debt have doubled since 2016.

Borrowers have also been keen to tap private credit markets. Total sponsor-backed middle-market loan volume jumped to a record $196 billion last year, in part fuelled by a resurgence of the M&A activity that had slowed in the early months of the pandemic. Borrowers are attracted to private debt because they tend to get their loans faster and there is more certainty of execution compared to public debt markets. There, borrowers typically have to wait for a favourable issuance window and deals can collapse if investor demand is insufficient.

 

Private debt strategies

Direct lending remains the most popular private debt strategy, accounting for almost three quarters (73%) of the market’s growth over the past decade, according to McKinsey. That growth has been supported by banks pulling back sharply from lending to middle-market companies due to regulatory capital constraints (non-bank direct lenders don’t have the same regulatory requirements). Banks now account for just 11% of sponsored mid-market financings, down from almost 70% in 2013, McKinsey said. 

Other private credit strategies include distressed debt (a riskier approach of lending to companies that are experiencing financial difficulties), mezzanine loans (a type of junior debt that has equity-like features) and special situations (debt that is cheaper to buy for a variety of idiosyncratic reasons).
Returns on private credit typically outperform public market debt. In the first three quarters of 2021, private debt generated pooled IRR (internal rate of return) of 10.1%. Those returns have been fairly consistent too, with private debt averaging a median IRR of 9.4% for vintages between 2008 and 2018. “LPs primarily look to private debt to deliver reliable, low-volatility returns that exceed fixed-income alternatives, which is exactly what the asset class has delivered over the last decade,” McKinsey said.

Private debt’s increasing popularity is reflected in significant inflows of capital. This remains one of the largest risks to its continuing outperformance. Here, manager selection becomes especially important in order to avoid potential excesses. More broadly, inherent risks include illiquidity, with private debt assets being less easily tradable and, of course, the higher leverage levels that tend to accompany times of expected interest rate rises.

 

Inflation-beating opportunities?

Private debt performance is expected to remain robust, particularly during the current inflationary environment. Because private credit tends to be floating rate in nature, as central banks lift interest rates to combat inflation, private debt interest rates rise in tandem.

Investors are already planning to increase their allocations to private debt over the next 12 months, according to a TMF Group and Private Equity Wire survey published in June. Almost 70% of respondents said they plan to increase their exposure to private debt, with more than a third (37.4%) saying they plan to amp up allocations by more than 20%.
 
AUM is poised to keep on rising. Preqin forecasts the private debt market will grow to $2.69 trillion by 2026, making it the second-largest private market asset class after private equity.

With uncertainty in public markets increasing and inflationary pressures weighing on conventional fixed-income credit, private debt’s broadening appeal is unlikely to slow anytime soon.