Private Credit Highlights and 2024 Outlook
Private credit managers are adapting fund structures and investment terms as institutional investors seek more customized risk and return profiles, and managers seek to tap the retail investor market. Find out more about the fund structuring trends shaping the industry.
Market Trends
Private credit has become a mature asset class since emerging as an alternate lending source in the wake of stricter constraints on banks, following the global financial crisis. A growing specialism for asset managers worldwide, private credit now includes categories as diverse as real estate debt, venture capital loans, and leveraged loans.
Inflationary pressures in 2023 and elevated interest rates in the U.S., Europe and Asia led investors to seek new sources of liquidity outside the public equities markets. Fundraising was tough, with a move to quality as large-cap, multi-strategy asset managers were seen as the best option during adverse financial conditions. Unlike other finance strategies, private credit continued to offer compelling results in 2023, with investors attracted to its lower volatility and higher returns compared to the leveraged bank loan and high-yield bond markets. Much of related lending is in the form of floating-rate investments that change with interest rates, providing interest-rate protection compared to investments such as fixed-rate bonds, as well as the advantages of pricing certainty and speed.
In the U.S., the regional banking crisis in early 2023 led to diminished trust in deposit-taking institutions and created a move away from traditional lending sources to private credit. By September 2023, the latter provided 86 percent of loans for the U.S. leveraged buyout market compared to 65 percent in 2021 (LDC News). Although private credit has grown fastest in the U.S., it now has a firm hold in Europe. Not only are U.S. private credit providers fundraising in the European markets, but the European private credit industry raised US$28.02 billion of new investment by the beginning of September 2023 (Preqin). In Asia, there was also considerable growth in this market.
There has been substantial growth in investments by insurance companies from various parts of the world through rated funds (as standalone structures, feeder funds and parallel funds) in which the capital structure is bifurcated into equity and rated debt. This allows insurance companies to receive better risk-based/solvency capital treatment for investments in private funds. The market in this area has expanded exponentially with more than 500 such structures being rated over the past several years and has led to expansion in this area with both major rating agencies and traditional structured product arranging banks joining the scene in a large way. It has also led to expanded structuring including rated funds feeding into BDCs and other types of registered funds as well as standalone strategies where insurers only hold the rated debt and the levered equity is sold to other investors such as tactical opportunity strategy funds, family offices and pension plans.
In fund formation, growing convergence between registered and private funds has led to traditional asset managers joining forces with alternative asset management providers to create innovative new fund structures. Business development companies and other closed-ended funds are increasingly being used by private credit managers to bring their product to a retail investor audience, as well as their traditional institutional investor client base.
Finally, 2023 was a robust year of issuance for both traditional and non-traditional middle market CLOs. This cut against the grain of the conventional wisdom at the start of 2023, which held that rising interest rates would dampen loan origination and related financing. Although it was certainly a challenging environment, the resiliency of private credit continued to marry well with overall investor appetite for the asset class.
Legislative and Regulatory Developments
In August 2023, the SEC adopted new rules and rule amendments to enhance the regulation of private fund advisers and update existing compliance rules. The SEC’s private fund adviser rule increased compliance obligations by requiring private fund advisers to issue quarterly fees, performance reports and to perform annual audits, as well as to disclose certain fee structures. It also bars private funds from offering some investors preferential treatment when it comes to portfolio exposures and ability to cash out. Change to the private fund adviser rules had a subsequent effect on markets in Asia and Europe.
The year 2024 will see the introduction of Basel III, the banking regulations designed to mitigate risk within the international banking sector. The regulation will require banks to maintain a certain leverage ratio and keep a level of reserve capital available. As non-deposit-taking institutions, asset managers are not directly affected by these reforms. However, since the start of the implementation of Basel III in 2009, businesses have come to increasingly rely on non-bank lenders, including private credit providers, and are likely to continue to do so.
Outlook
Private credit is predicted to grow in 2024, as numerous leveraged loans and high-yield bonds reach their maturity wall and will need to be refinanced. With M&A volumes down, investors will be looking for new ways to exit investments. We anticipate increased activity in the secondaries market while net asset value financing is likely to provide liquidity to funds. Many businesses have been successful in finding ways to service debt in the elevated interest-rate environment but, if unfavorable market conditions persist, this could lead to a rise in borrower defaults and resultant distressed debt transactions and restructurings. This may, in turn, lead to consolidation among smaller private credit players.
The U.S. market is highly sophisticated in the scale and complexity of market strategies available. With the private credit arms of Ares, Blackstone and Apollo having expanded into Europe, that market is poised for further growth, although variance between jurisdictions poses challenges. With a slowdown in fundraising from institutional investors, private credit funds are looking to Europe’s retail investors as another investor class, seeking to emulate the well-developed U.S. retail market. Two new fund structures, the UK’s Long-Term Asset Fund and the European Long-Term Investment Fund, may facilitate investment in long-term, illiquid assets for an investor base that allows the inclusion of retail investors. The private credit market in Asia is also set to continue its pattern of upward growth. In addition, increased interest in options for rated offerings has expanded the universe of rated funds with rated structures being offered to insurers in Canada, Mexico, Bermuda, Europe, Korea and other Asian countries and we expect to see extensive growth in this market globally.
It should also be noted that the “middle market” sector continues to broadly diversify in terms of both underlying assets and financing options. We expect these trends to continue in 2024; in particular, we would expect that non-traditional CLOs (aka, “private CLOs”) will comprise a substantial portion of issuance for issuers of all sizes in this new year.
Sector Matter Highlights
- Dechert represented Centerbridge in the establishment of a strategic relationship with Wells Fargo & Company focused on direct lending to non-sponsor North American middle market companies. To meet the alternative credit needs of this segment, Centerbridge launched Overland Advisors to manage a newly formed business development company that will be primarily focused on making senior secured loans. Overland represents a transformative new business model for direct lending to middle-market companies, diversifying the market of clients served by private credit and direct lending.
- Dechert advised Blackstone Credit & Insurance and its related funds, accounts and joint ventures in connection with more than 22 individual financings transactions totaling over US$25 billion, including asset-based financings, rated and unrated structured financings, unsecured issuances and other bespoke financing transactions notable for innovative structuring at various levels of the capital structure.
- Golub Capital, a direct lender and private credit asset manager, instructed Dechert to help structure its 69th collateralized loan obligation (CLO). Valued at US$1.3 billion, the transaction is the largest CLO closed in 2023. Dechert’s success builds on the firm’s experience in the formation and operation of CLO platforms, along with related regulatory compliance issues. Dechert has established itself as a pioneer in CLOs, leveraged loan warehouse facilities and asset-backed securities transactions.