By Edouard Jordan, Carlo Orlandi, and Moritz Ogon
Introduction
One of the hottest topics in finance right now is the explosive growth of funds that lend money directly to finance buyout deals and highly indebted businesses. We are talking about Private Credit, also known as Private Lending or Direct Lending. The $1.5tn industry anticipates growth, especially as businesses, amidst rising interest rates, turn to alternative credit providers as an attractive solution for refinancing their debt. Shoemaker Cole Haan, software developer Hyland Software, and fintech group Finastra are all examples of businesses that have incorporated Private Credit in their refinancing strategies. On the lending side, Blackstone, Apollo, KKR, Carlyle, and Ares Management are among the industry’s biggest players actively expanding their offerings towards Private Credit.
Historical Trends
The surge in the Private Credit market occurred following the 2008 financial crisis when the SEC imposed stricter regulations such as additional capital requirements on public banks. Regulations are of great importance, as the eight U.S. G-SIBs (Global Systemically Important Banks) had $1.1tn in total capital reserves at the end of the second quarter of 2022 (compared to $678 billion at the end of 2008), with an average Tier 1 capital ratio of 13.6% (compared to 10.2% in 2008). While banks scale back their lending operations, non-bank lenders have stepped in to fulfil the ongoing need for businesses seeking debt financing.
On-Paper Strengths and Weaknesses
Private Credit investments are advantageous in their resilience to rising rates as most loans are floating-rate, leading to higher interest payments by borrowers in case of rate rises. They also offer better returns than publicly listed leveraged loans, featuring an illiquidity premium. Additionally, Private Credit thrives due to fewer bureaucratic hurdles compared to traditional bank lending, on top of more flexibility in terms of investment criteria and decision-making.
However, these investments also carry risks: as rates climb, highly leveraged borrowers might face financial distress, potentially resulting in defaults. Moreover, inflation poses threats, particularly to businesses unable to offset growing costs. For instance, rising energy prices could trouble producers and suppliers of services since they come with an increase in manufacturing costs while consumer spending recedes.
Private Credit Profitability
Investors in Private Credit are currently getting better returns than they would from Private Equity. The State Street Private Equity Index, which collects data from about 3,900 funds with $4.8tn in capital commitments, calculated that Private Debt funds returned 2.61% to their investors in Q2 of 2023, while buyout funds returned 2.29%. Moreover, since the start of 2022, Private Credit has been ahead in all but one quarter.
This trend conveys the direction of the market as fundraising in both the Private Debt and Equity spaces has suffered this year, with the former doing slightly better. so many factors are pushing Private Credit allocations upward.
In stark contrast, Private Equity firms have been watching the value of their holdings decline and they’re finding it harder to buy and sell companies. This is partly because the cheap-money boom years have ended. That in turn depresses the amount of cash they can return to their investors, leading to discontent.
To protect themselves from the impact of central bank tightening, lenders in the $1.6tn Private Credit market charge borrowers interest at a variable rate. Despite the fact that pegged interest rates have enabled Private Credit funds to make higher ROI for investors, companies that borrow from them fear what spiraling interest costs might do to them.
Highly indebted borrowers will continue to struggle to meet their payment obligations, causing defaults and an uptick in restructurings. This will especially impact those direct-lending funds that have marketed aggressively priced loans to cyclical businesses. Cécile Mayer-Lévi, Head of Private Debt for Tikehau Capital, even stated that the changing rate environment “has led to many challenging and concerning situations”.
PE Problems
All these events have made life harder for Private Equity firms, who need to convince LPs to hand them money for investments usually riskier than those Private Credit offers. This is because equity holders lose money before creditors do if a company faces liquidation – company assets are sold and proceeds distributed according to the seniority of the claim. Thus, investors expect returns to reflect that extra risk.
All private markets have suffered a slowdown in fundraising this year, but Private Debt has proportionately been attracting more capital than its equity counterpart recently. Money available for deals has been falling since July 2022, while Private Debt has experienced an increase, according to Nan Zhang, State Street’s Head of Product Implementation and Alternative Investment Research. Indeed, the amount of cash Private Equity funds can return to their investors has dropped since the beginning of 2022.
As the macroeconomic environment has become more uncertain and volatile over the past two years, Private Equity firms have struggled to exit their portfolio companies. Buyers and sellers are far apart on valuations, leading many funds to hold on to their investments rather than sell them for a depressed price, returning less money to LPs.
As Private Debt enjoys continuous interest payments, distributions to investors have largely stayed stable. Therefore, Private Debt Investments also have an end repayment date in the maturity of the loans, whereas Private Equity funds must sell a company or find other creative ways to return the capital invested.
Current Developments
Recently, Private Credit managers have raised funds and set up partnerships to invest in the transition from fossil fuels to clean energy as direct lenders look to help fill a $9tn annual financing hole. For instance, Brookfield Asset Management said this month that it had raised $6bn to make infrastructure debt investments, focusing on businesses including renewables.
Also, Société Générale launched a fund with Brookfield that will increase clean energy investments, mirroring the industry trend. At the same time, Blackstone has raised $7bn to invest in clean energy, creating one of the largest funds focused on the energy transition. Energy Capital Partners also raised a fund, ECP ForeStar, with an initial volume $2.5bn. Soon after that, ECP was acquired by Bridgepoint Group. Separately, Rabobank Group set up a new platform for sustainable Direct Lending.
The global economy will need about $9.2tn of annual investment through 2050 to move from fossil fuels to clean energy, according to a McKinsey & Company study. Banks have been a key source of debt capital, but the regional banking crisis in the US has cut into the supply of credit in the banking system. All of these events turned out to be a pickup in the opportunity for Private Credit in the energy sector. The disruption of capital supply has made Private Credit capital more valuable, especially as borrowers may not have enough equity to fill the gap.
The Inflation Reduction Act, viewed as President Joe Biden’s signature climate legislation, is further encouraging demand for all forms of capital, including Private Debt. A systemic shift to sustainability can be seen in the US. Across various sectors, the order of magnitude for the capital needed is tripling. The law offers tax incentives and thereby encourages clean energy investments.
According to a Goldman Sachs study, money is already flowing into solar manufacturing, electric vehicles, and similar projects. A lot of the economic funding won’t be coming from the government according to Ike Emehelu, Co-Head of Akin Gump Strauss Hauer & Feld LLP’s Projects & Energy Transition practice. There can be real risks in energy transition investments, and not every money manager is interested in the space. The profitability of renewable energy projects can hinge on commodity prices, political policies, and other variables that add extra complexity to investment analysis.
Brightwood Capital Advisors did energy, thermal and wind investing up until the last decade, but has since stopped their involvement. According to Sengal Selassie, the Chief Executive Officer and Founder of Brightwood Capital Advisors, “there are still too many macro factors to make it work and more volatility there which makes it challenging for credit investing.” However, to many investors, the large amount of capital that renewable energy requires has good potential to translate into high returns for providers of those funds. Overall, there have been $270bn in announced new projects over the past year in renewable energy, manufacturing, and supply chain, as pointed out by Robert Horn, Global Head of the Sustainable Resources Group for Blackstone Credit. That’s equal to the last eight years combined.
Recent Deals
Ares Management Corp. and Thoma Bravo’s credit division provided a $220mn debt facility to Exostar LLC as part of its acquisition by Arlington Capital Partners.
Grindr Inc. is working with JPMorgan Chase & Co. to refinance a roughly $200mn loan with lenders including Fortress Investment Group.
Vedanta Group is in advanced talks to raise a $1.25bn private loan as it seeks to overhaul its debt.
Ares Management Corp. served as a joint lead arranger and a bookrunner for a $125mn debt facility to Keter Environmental Services.
Zotec Partners is refinancing debt via a $315mn direct loan from Francisco Partners.
Private Lending funds are working on early-stage plans to provide as much as €1bn to finance the potential buyout of Gossler, Gobert & Wolter.
Further Trends
Private Lending to Real Estate developers is a good business now, after banks that are too exposed to office buildings have pulled back on financing commercial properties. At the same time, more individuals are looking for living space that they can work from since the COVID-19 pandemic has drastically changed people’s working habits. Higher incomes are contributing to creating the best opportunities in over a decade for Private Credit, Distressed Debt and Real Estate Lending.
Companies are struggling with higher interest rates and defaults will rise from current levels of under 2%, to around 3% to 4%, but that is still below historical levels of 6% to 7% during recessions. Amid distressed debt, there are opportunities in media, cable providers and health care. The biggest variable explaining the outperformance of distressed debt funds had to do with the year investments were made. If the fund was raised the year before defaults spiked, inevitably that will be a great year for investing in distress. Market observers expect more consolidation among CLO managers, as small firms have a hard time collecting sufficient funds.
Involvement of Authorities
Currently, authorities tasked with preserving financial stability see Private Credit with cautious optimism; they recognise its growth but voice concerns about its limited transparency and oversight in comparison to traditional banking establishments. The industry as a whole often only reveals basic data.
Examining the current trajectory of Private Lending also reveals possible implications for commercial banks. According to Proskauer’s Private Credit Default Index, the Private Credit default rate has been rising significantly, increasing from 1.0% in the previous quarter to 2.15% in the first quarter of 2023 (Proskauer). Motivated by the need to maintain a good performance history, Private Credit lenders can decide to favour covert debt restructuring talks over formal default announcements, creating doubts about the true financial stability of the sector. The Federal Reserve recognised the problem of transparency in the private loan market in a study published in May. It stated that it impedes the evaluation of the risks to the financial system as a whole. The inclusion of retirees investing in Private Credit funds, alongside more sophisticated investors, further complicates the landscape. It is reported that US public and private pension funds hold roughly 31% of Private Credit fund assets, amounting to $307bn, while insurance companies own approximately 10% (Bloomberg).
A number of US senators, one of them being Massachusetts’s Elizabeth Warren, are pointing out how hazardous and competitive Private Lending funds are. They are calling for more checks and balances and proposed regulations that would require private funds to reveal more information in a letter they wrote to the Securities and Exchange Commission in May. They drew attention to the fact that these private lending funds operate with less control than banks, despite being in direct competition with them. However, there are more issues with private financing than just risk related issues. Significantly indebted businesses which are unable to make their payments face challenges due to persistently high interest rates, as their financing becomes more expensive. This poses a risk, as many smaller asset managers who have rushed into Private Credit have never experienced a serious economic downturn and could therefore be in for unpleasant surprises.
Conclusion
Some investors believe that things are working fine as they are, with banks dealing with safer loans and private lending experts taking on riskier long-term investments. But the industry’s drive to pull in individual investors is adding to the volatility in the private lending market. As we potentially edge closer to a financial crisis, private lending fund heads being summoned to Washington, together with bank CEOs, underscores the need for a closer look at what the industry is doing and how it needs to be regulated.
Sources
https://www.ft.com/content/7c4a994b-024e-4e6e-992c-7409de8943ed
https://www.fdic.gov/bank/historical/history/3_85.pdf
https://blinks.bloomberg.com/news/stories/S3QW29T0AFB4
Comments are closed.