In the decade following the global financial crisis, the private debt market experienced a purple patch achieving year-on-year growth. The low-interest environment and the retrenchment of the banks from lending provided ideal conditions to encourage this.

The asset class grew in size and familiarity but there was perhaps a lingering concern that many of the managers and strategies had not been tested as they lacked the track record of performing during a downturn.

There were probably very few scenario testing simulations that had anticipated large sections of the global economy coming to a virtual standstill almost entirely overnight.

With cash-generating activities reduced to zero, the last two years have provided a fairly vigorous stress test which by in large the asset class appears to have passed with flying colours.

As we emerge out the other side, moving from pandemic to endemic, the signs are good that the asset class will continue its growth story. Statistics from June 2021, provided by Preqin, show private debt AUM slightly behind real estate but on a trajectory to overtake in the near future becoming the second-largest asset class behind PE.

In this article, I wanted to explore the opportunities and perhaps a couple of the threats to private debt in the short to medium term. To do so, it is worth taking a closer look at the strategies within the asset class and what the trends are telling us.

In the early years, distressed debt lead the way from a funding perspective, which was understandable given the landscape following the GFC. However, since 2014 direct lending has been the dominant strategy. In 2020 fundraising for direct lending slowed and distressed debt had a resurgence as capital flocked to capitalise on the anticipated opportunities. Perhaps due to government intervention or the approach of forbearance above foreclosure, the distressed opportunities have not been as available as anticipated and fundraising has shifted back to direct lending in 2021 and so far in 2022.

As government intervention falls away perhaps the bad businesses that have been artificially propped up will start to be exposed and the distressed opportunities will have just been delayed. A quote I took from a debt conference on the value offered by distressed debt investing has stuck with me :

“People do not love distressed assets, and therefore they undervalue them”.

As a result, I suspect that distressed debt will perform well and provide a valuable tool to the real-world economy. I also see continued growth for direct lending. Although private debt is soon to be the second biggest asset class in terms of AUM, it will still be some way behind the largest, being PE. And this provides a continued opportunity.

As PE managers look to maximise returns for their investment, they will increasingly turn to leverage to enhance their returns. As the banks are less and less likely to provide this it will continue to provide opportunities for debt fund managers.

On the flip side, sponsorless lending continues to be a great untapped opportunity. Lending to borrowers that do not have a PE sponsor provides a number of benefits:

1). Commercially the risk premium can add approx. 1.5 to 2% on to the rates available.

2). The owners of the borrowers tend to work tirelessly to ensure they repay their debts.

3). The owners of the borrowers tend to work tirelessly to ensure they repay their debts.

Lender covenants are included fully and in the event of a pandemic like scenario companies not backed by PE sponsors are more likely to receive government support. Therefore non-sponsored lending should see strong growth over the short to medium term.

In terms of the smaller challenger strategies venture debt feels like it is the one to watch. Market analysis performed by Preqin showed that venture debt offers one of the highest IRRs (within private debt) whilst providing the lowest risk. That is obviously a strong proposition and if investors move to private debt from PE they will need to look to the areas of the asset class where double-digit returns can be achieved.

One of the hottest topics on the conference circuit at the moment is the perceived challenge from inflation and the potential interest rate increases to combat this. For the most part, interest rate increases are not expected to halt the attractiveness of the asset class. Although private debt flourished in a low-interest environment most debt instruments involve floating rates and will therefore provide a return above the current risk-free rate. However, this view perhaps ignores the increase in the cost of capital for borrowers and the potential impact this could have on their ability to repay, this is of course the ultimate requirement for any successful lender. But, the usual stance is that interest rate increases are bad for the bond market. Any increase in rates could see capital leave bonds and be reallocated to private debt within fixed income portfolios resulting in additional growth for private debt. Therefore inflation appears to be a challenge and an opportunity for private debt.

One challenge that is recognised by investors and managers alike is deal flow and the amount of dry powder in the asset class. Given the bumper fundraising of recent years, this is perhaps not a surprise but to continue to attract new investors, this capital needs to be put to work. As alternative lenders become more prominent in the marketplace, banks continue to move away, and deal size continues to increase, this will perhaps alleviate the concern.

On balance the outlook is positive. There are challenges ahead but to date, private debt has proved itself to be up to those challenges and the fundamentals remain strong. There is a real economic benefit to the asset class and real growth potential so in my opinion, private debt remains an exciting area to be.