Trends, diversification and relative value in private debt

Growth in private debt AuM

The private debt asset class enjoyed dramatic growth during the extended period of low interest rates. Most fundraising has been in direct lending, with smaller allocations to real estate, mezzanine, and distressed strategies. While the current rise in interest rates might reduce the rate of growth momentarily, we think that other factors will continue to drive both borrower and investor demand for private debt.

Borrowers’ demand for private debt financing

Direct lending has grown into the largest component of the private debt asset class, as the banking system could not meet sponsors’ demand for M&A-related financing. More broadly, long-term structural changes within the banking system, including the reduction in the number of lending institutions and branches, are driving the growth of the private debt asset class. Consolidation may improve the banking industry’s efficiency and profitability, but it reduces access to bank lending, especially for smaller borrowers. The undersupply of bank credit should continue to drive borrowers’ demand for private debt.

Coming into 2023, it was generally accepted that a rising-rate environment would be positive for the banking sector, as net interest margins would improve. The collapse of Silicon Valley Bank (SVB) has demonstrated that this rule of thumb would not work for every bank. We expect uncertainties in the sector to lead to a further contraction in bank lending, supporting the growth of the private debt asset class.

Investors’ demand for private debt

The disappointing performance of public debt markets over the past decade has led investors to increasingly consider private debt as a suitable yield strategy to complement their allocation to public debt markets. Private debt has unique and attractive characteristics, including relative yield, lower volatility of returns, diversification benefits, and the potential for inflation mitigation.

For some investors, relative liquidity argues in favour of allocating to public markets. However, the experience of SVB reminds us to be cautious: liquidity and price risk do not always sit well together. When allocating, it is better to be clear whether the objective is liquidity or yield, rather than to conflate liquidity and yield.

Private debt: opportunities in a growing asset class. Why now?

Low duration, floating base rates, true diversification and relative value make private debt an attractive investment opportunity. With the banking system already unable to meet financing needs, the recent US bank failures and the demise of Credit Suisse are expected to cause a contraction in bank lending. Constrained bank lending will provide opportunities for private debt lenders to achieve an attractive premium relative to public markets. We continue to see investors finding diversification and relative value, along with low volatility, in private debt, without taking on duration risk or significant country risk. The emergence of new sub-asset classes and investment themes further expands opportunities within the private debt landscape.

Colin Greene
Head of Private Debt
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