Private Credit Outlook: The Heat is On

Private market growth in recent years has been remarkable. We think there's more to come.

Competition for capital is heating up with the weather—a trend we expect to continue in the second half of the year as banks attempt to regain market share. But investor demand for private credit remains high, and we expect it to rise as the opportunity set continues to expand beyond corporate credit.

In recent months, increased bank lending in the broadly syndicated loan market is flipping the script, which over the past couple of years has involved direct lenders steadily displacing banks as a source of capital in larger private equity buyout deals.

But the structural forces that have driven the rapid growth of private credit over the last decade, including stricter banking regulations, remain in place. And companies have grown accustomed to the speed and greater certainty of execution when dealing with private lenders.

For investors, that means more opportunity. Direct lending to middle-market companies checks in at about $1.5 trillion today, according to Preqin, and is on track to exceed $2 trillion by 2027. And at $6.3 trillion and growing, the consumer-oriented asset-based finance market is many times larger and provides financing for residential and commercial property, cars, credit cards, small business loans and other types of credit that grease the gears of the real economy.

We think both belong in a diversified portfolio. Judging by their strategic asset allocations, investors agree. Private assets in general have been among the fastest growing components of allocations over the past decade. Why? We believe it’s because investors see the value in thoughtfully incorporating these less-liquid assets into their allocations to increase return potential, particularly relative to public credit.

Direct Lending: Navigating the Risks

For many investors, corporate credit will remain the linchpin of their private credit allocations. While spreads have narrowed across public and private markets, the base rates used to price private corporate loans are likely to stay above their long-term averages, and illiquidity premiums on private debt remain intact across the risk spectrum.

We think this makes private credit attractive on an absolute basis and relative to private equity. Put simply: it’s a good time to be a lender, and we still see potential to generate returns that may help to offset any losses tied to borrowers who struggle with higher rates.

Finding an experienced lender with the ability to maintain relationships with borrowers is important though—particularly now that a late-cycle decline in deal flow has made it tougher to deploy capital.

In our view, focusing on the core middle market, where covenant protections are typically strong, would serve investors well. This covers companies with annual earnings before interest, income tax, depreciation and amortization between $10 million and $50 million.

Demonstrated industry expertise over multiple economic cycles is also crucial. In a market that has grown as rapidly as direct lending has over the past decade and a half, experience and track record among lenders can vary quite a bit. As we see it, the due diligence process is crucial.

Beyond Corporate Lending

With spreads getting tighter and the ever constant of market uncertainty, it’s important that investors widen the opportunity set. One way to do that, in our view, is to lean into private credit’s role in financing the everyday activities critical to a functioning modern global economy.

Asset-based finance—sometimes referred to as specialty finance—encompasses consumer, residential and commercial credit and remains underrepresented in investor portfolios.

These loans are typically self-amortizing and can help to diversify exposure to private corporate credit in the US and Europe.

But the wide variety of private lenders means that underwriting standards on originated loans may vary considerably. In our view, how soundly a loan is underwritten is one of the most reliable indicators of performance. That puts a premium on managers who can build strong relationships with originators and who have the infrastructure in place to assess the risk and performance potential of thousands of underlying assets.

Financing the Energy Transition

Another secular trend: private capital’s role in financing renewable energy and the clean technology of tomorrow is also increasing opportunities for investors, particularly as banks retreat from financing such projects.

It has become common for private capital providers to finance multiple stages of project financing. For example, this may include the actual construction of a solar plant as well as many preliminary steps, including the deposits needed to secure building sites and acquire equipment and the “offtake agreements” with partners who commit to purchase the energy. 

We continue to see opportunity in large or growing solar-power markets, notably in Europe, where pressure on equity returns has widened the opportunity set for private lenders.

Real Estate: Looking Ahead

When it comes to commercial real estate, we expect high rates and above-target inflation to continue creating hurdles for valuations, making some loan modifications challenging.

Transaction volumes have been slow to recover in the first half of the year, but may pick up as bid-ask spreads narrow and as rates moderate slightly. There may even be opportunities for selective investors at the top tier of the office market. But investors will need to pick their spots carefully.

A Good Fit for a New Regime

Nothing moves in the same direction forever, of course. But when it comes to private credit opportunities, we think there’s a strong secular case to be made for more growth.

Some of the reasons go beyond near-term market conditions. For example, we believe private credit can help investors cope with a changing global macro environment defined by higher inflation and lower real growth.

In the years ahead, we think generating the returns necessary to stay ahead of inflation will become more challenging. We believe that will raise the value of the illiquidity premium associated with many forms of private credit and the inflation hedge that many floating-rate structures provide.

We expect competition in the private capital markets to persist in the second half of 2024. But we believe that private credit’s increasingly central role as a financier of today’s economy will continue to expand. For investors, that may provide opportunities to diversify their asset allocations and increase exposure to the real economy.