Private debt: the emergence of an asset class

Let’s start with 2023 and the wider backdrop for private debt investing?

On reflection, 2023 was a year of two halves. The first half of the year was dominated by rising inflation and rising interest rates, creating economic uncertainty. Investors were reluctant to put their money to work due to the denominator effect and a lack of return of capital and we also saw a significant slowdown in mergers and acquisitions (M&A) activity.

The second half of the year saw rates peaking, towards year-end, and despite low growth persisting, a degree of investor confidence returned as inflation slowed and the fear of recession receded. With this backdrop, M&A activity then started to pick up.

It is a particularly rewarding time to be invested in private debt – the asset class continues to grow both through being companies preferred route of financing and investors’ increasing allocations. In a market of sustained inflationary pressure the floating rate structure provides implicit protection and pass through of base rates. Naturally, the wave of interest rate hikes over 2023 has put more pressure on companies due to a higher cost of capital but credit selectivity with a focus on companies with pricing power and business strength can provide attractive all-in-yields, especially in direct lending.

With banks continuing to step back due to regulatory pressure and companies staying “private for longer” demand has also started to outpace supply. This coupled with a lower valuation environment creates a compelling opportunity in more growth and opportunistic financing strategies for investor’s looking for higher returns.

Direct lending largely finances M&A and so investment activity tends to dictate the level of opportunity available. When there are fewer deals, there can be more competition in the market (for fewer deals) – this can drive down pricing (in turn lower returns) and weaker investor protections.

Appetite from both investors and companies in middle-market direct lending continues to grow. This is, in part, through the resilience the asset class has shown over a variety of business cycles. And that was demonstrated over 2023 with consistent returns.¹

What’s key; is picking resilient non-cyclical companies with pricing power and business strength, that are able to service their debt despite changes in base rates.

Some of that demand will historically have been met by the banks. What’s changed?

Increasingly, since the global financial crisis (GFC) we’ve seen retrenchment from the banks as they’ve managed capital adequacy requirements and shrinking balance sheet capacity. Similarly, there have been fewer public markets bond issuances and a drop in syndicated loans in the US and Europe in particular in 2023. For middle-market companies looking for debt financing on flexible terms, there have been relatively few options in the post-GFC environment. As demand from companies has grown, so too has the opportunity set for investors incorporating private debt into their asset allocation mix. We expect that the private debt market is going to grow from about US$1.7trn today to something in the order of US$3.5trn in the next five years.²

There is no guarantee that any forecasts made will come to pass.

And besides the market fundamentals, what else is driving this growth?

When you look at the construction of the average investor portfolio, private credit is arguably under-utilised. The weighted average allocation to private debt among pension funds and insurance companies, for example, is still relatively small in our opinion, when compared to institutional allocations across the market. We see plenty of scope for growth from owners of long-term capital such as these.

What benefits are investors looking for from a portfolio construction point of view?

A steady income stream is top of the list for many investors but of course diversification and low volatility are also important considerations. Private credit has provided low-correlation to listed assets in both fixed income and equity where we’ve seen a lot of volatility in recent years.³

Naturally, investors have taken note of some strong returns in the private debt world, too.⁴ We’ve had the pick-up from base rate rises which has enabled double digit returns for senior, secured credit risk. Clearly this has proved attractive for investors seeking some inflation protection.

During my thirty-year career, I’ve never seen this level of returns in private debt.⁵

What does the picture look like for new investments, with inflation falling?

Sticking with private equity for the moment, who were strategically quite defensive last year, there’s a lot of dry powder out there, particularly in Europe, which investors would like to deploy. Inflation is coming down very rapidly and the pickup in M&A activity I mentioned is likely to accelerate.

There’s an expectation now that interest rates will start to come down gradually, confidence will improve, deal flow will increase, and the so-called denominator effect will be less of an issue. As this dynamic unfolds, the knock-on effect to private debt remains positive given the current attractiveness of the asset class.

And do you think the conditions for private debt will remain attractive?

I do. Like most investment asset classes though, stewards of long-term capital need to be comfortable with a buy-and-hold strategy. BlackRock, like other providers, offers closed-end private credit funds, it is not an asset class you can trade in and out of, but this is also why it performs better over time. In a case a company goes through any issues, you have the time to work through the problems and retain value if you have adequate restructuring capabilities in place.

We’re seeing a lot of encouragement from the government to invest in domestic, growth companies. Does private credit have a role to play there?

Absolutely. Within the private debt asset class most investors are familiar with direct lending, but there are also vehicles such as credit opportunities, special situations funds and even venture debt.

There is a lot of appetite for investment in tech, healthcare and the transition to a low-carbon economy, and we think that these structures will have an important role to play in those growth sectors which speak to the government’s ambition.

In Europe, for investors who are already comfortable with direct lending and want to diversify their private credit allocation, there could possibly be more opportunities in these potentially higher yielding strategies, for example, in credit, special situation funds, and even venture debt. For those looking to diversify their credit portfolio, these funds could have attractive risk/return profiles.

I guess the strategic shift away from equity within the LGPS is also a driver here?

Broadly speaking we have seen administering authorities of the schemes sell down some public markets equities and make way for greater private markets allocations. What is interesting, I think, is that we are seeing allocations of private debt form in both the alternatives and fixed income buckets, to play across the liquidity spectrum. Generally, private debt is being seen increasingly as an asset class in its own right – split across the spectrum for investment grade private placements, direct lending, opportunistic and more stressed or distressed debt.

How is BlackRock adapting its private credit offering to the LGPS specifically?

For our flagship European direct lending fund we always launch a parallel sterling denominated vehicle to better meet the requirements of our LGPS clients, such as enhanced reporting, aggregating schemes and pools to offer compelling fees. Essentially, we wanted to create something that is both mindful of the LGPS’s economic considerations and which also provides ease of access to the asset class.

I joined BlackRock in 2014 to build out our European Middle Market Private Debt platform (EMMPD). With boots on the ground in core geographies, to date we have raised over £600m across the LGPS channel and focus on ensuring strong investor protections with attractive returns.⁶

The LGPS community are committed to sustainable investing. How are you partnering with clients to achieve these goals?

This is really important to us and something we have incorporated in our investment process since the launch of EMMPD. We have a sustainable investing team within the credit function who are responsible for engaging with portfolio companies. They work alongside our investment team to understand where companies are on their climate journey, help set achievable objectives and where appropriate the right Environmental, Social and Governance (ESG) incentives through ratchets.

And can private credit play a role towards impactful stewardship?

Very much so. There are a lot of ways a debt investor can have a positive influence. A lot of middle market companies, for example, are yet to start their net zero journey but we know through engagement with our portfolios that over 70% want to have the conversation.⁷ As a lender, you can introduce the company to a wide range of resources, you can structure the financing to provide incentives and penalties when necessary. Even engagement with private equity sponsors has really helped the industry to move forward.

Our teams have taken into account ESG integration in private markets since 2019, including our ESG risk scorecard and toolkit, annual borrower-level data collection since 2020 and widespread adoption of ESG margin ratchets.

Our private credit team members are deeply involved in industry initiatives to improve data collection and convergence across private markets and we collaborate and hold leadership positions with a number of organisations, including the IIGCC, IDP, AIMA, UNPRI and LSTA.*

Lastly, what’s your take on the concern over default rates?

Default rates are around 1.5% at the moment in Europe, so considerably lower than some of the more pessimistic projections we saw last year.⁸ The interesting thing about defaults for me is the difference between public and private markets. In public markets, where you don’t have debt covenants, a default is generally a default on payment. Conversely, in private markets you will often see defaults on the covenant well in advance of any payment default. That enables you to work with the portfolio company to reset the covenant to provide them with more headroom, and with the private equity owner to encourage them to inject additional equity as a quid pro-quo. It’s in everyone’s interest that the company gets through a tough patch and in private credit you will typically capture any risk of payment default much earlier in the process.

Sources and footnotes

1. BlackRock, as at 30 November 2023
2. Preqin, as at 3 January 2024. 2024-2028 are BlackRock estimates. Private debt excludes Real Estate and Infrastructure
3. Morgan Stanley, 15 September 2023
4. LSEG Datastream, as at 3 January 2024
5. MSCI, as at 9 January 2024
6. BlackRock, as at 13 March 2024
7. BlackRock, as at 31 December 2023
8. Lincoln, Private Market Perspectives: European Edition, as at 31 December 2023

*The Institutional Investors Group on Climate Change, Integrated Disclosure Project, Alternative Investment Management Association, UN Principles for Responsible Investment, Loan Syndications and Trading Association.

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