After seeing its resilience tested like never before during two years of pandemic-related disruption, the private debt market is poised to grow as yield-hungry institutional investors expand their search for high-performing assets. .
The public health emergency lockdowns in 2020 delivered a series of hammer blows to borrowers, driving up default rates and creating new debt repayment challenges for private and public companies. Central bank stimulus programs have limited the damage and helped private debt weather the effects of the economic downturn.
Default rates on private loans in the United States peaked at 8.1% in the second quarter of 2020 before falling back to 1.04% in the fourth quarter of last year, according to the Proskauer Private Credit Default Index.
The rise in private debt is being driven by investors’ search for higher yields in a prolonged period of low interest rates and recent equity market volatility. Institutional investors are allocating their portfolios more to the asset class and turning away from more traditional assets to take advantage of the returns offered by private debt. Industry participants said they see no signs that enthusiasm for the asset class will wane this year.
“There is a growing trend to turn a small portion of your fixed income portfolio into direct lending funds,” said Jess Larsen, founder and managing director of Briarcliffe Credit Partners, a dedicated private credit placement agency, noting that investors were disappointed with the diminishing returns generated by traditional fixed income securities.
Last year was a banner year for private debt, with funds dedicated to the asset class reaching $191.2 billion, the highest annual sum since 2017, according to PitchBook data.
In a sign of investor confidence in the strategy’s continued strength, Blackstone raised $32.6 billion for its new private credit fund last year, which invests primarily in senior loans. Also last year, Ares Management raised $8 billion for an oversubscribed direct lending fund, nearly double the amount it originally targeted.
Larsen added that some of the top retirement consultants have also advised their clients to take capital from other parts of their portfolios, such as private equity and absolute return strategies, and reallocate it to debt. private.
Some large US pension funds have increased their allocation to private debt as they look for ways to boost investment returns.
Two of the largest pension funds in the United States – the nearly $482 billion Calpers and the $320 billion California State Teachers’ Retirement System – both increased their private credit allocation last year . Under a new four-year plan, Calpers has set a private debt allocation target of 5%, alongside other moves to increase its exposure to alternative assets, as the pension manager struggles to meet its investment return target of 6.8%. CalSTRS also added a 5% target allocation to private credit as part of its 13% allocation to fixed income, according to a July report from the repo manager.
Meanwhile, credit managers such as Barings BDC, Golub Capital, PGIM Private Capital and Benefit Street Partners announced a record amount of private debt creation, fueled by an acceleration in the flow of M&A deals over the past few years. last quarters.
Despite this optimism, private lenders are monitoring threats to the borrowing market, including the possibility of higher interest rates and rising inflation.
The Federal Reserve has signaled its intention to raise the federal funds rate to near zero from March as inflation climbed. Consumer prices in the United States hit a four-decade high of 7.5% in January, well above the Fed’s target.
While Russia’s invasion of Ukraine may affect how quickly the Fed raises rates, the dispute is unlikely to alter the US central bank’s overall policy approach.
As rates rise, the floating rate structure used by many private credit instruments offers investors the promise of higher returns, but it would also increase costs for borrowers.
And some credit market experts said even a series of rate hikes over the next two years would still leave prevailing rates at relatively modest levels.
“The Fed is signaling a rate hike of at least 1% this year, with analysts predicting another 1% hike in 2023,” said Randy Schwimmer, co-head of senior lending at Churchill Asset Management. “That takes us to a federal funds rate of about 2% by the end of next year, still modest from the 5.5% we had in June 2007. We still have a long way to go. to go before reaching the higher interest rate before the 2008 financial crisis.”
Data on interest coverage ratios, which measure a company’s ability to pay interest on its debt and are one of the main measures of risk in private debt markets, also suggest that borrowers are in average better able to withstand higher interest payments than in the 2007-2008 financial crisis, said Ian Fowler, co-head of Barings’ Global Private Finance group.
“Back then, your average interest rate coverage ratio was about two times, and today, just looking at our portfolio, the average interest rate coverage is three times or north of three times, that which gives companies more cushion to withstand higher interest rates,” Fowler said. .
However, it is important for borrowers to manage their exposure to higher interest rates, he said.
“Historically, it was common in loan documents for companies to fix 50% of interest rate exposure,” Fowler said. “It’s been out of the document over the last five or six years because we’ve been in a very low interest rate environment. It would be beneficial for all parties if that language finds its way back into the legal documents.”
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