Private debt has grown quickly over the last decade. But as the macroeconomic backdrop has deteriorated, this asset class has not been immune to challenges.
According to a McKinsey analysis of Preqin data, private debt fundraising increased more than fivefold from US$44 billion in 2010 to US$224 billion in 2022, but as interest rates have climbed and investors have pared back their allocations for private markets, private debt fundraising has slowed. Deployment has also cooled. According to McKinsey’s analysis of Refinitiv figures, there has been a 16% decline in direct lending to sponsor-backed mid-market M&A deals from 2021 to 2022.
In addition to drops in fundraising and deal flow, many private debt managers are also dealing with an increase in distress within their portfolios. In the direct lending space, for example, loan default rates hit 4.2% in Q2 2023, almost double the 2.2% rate observed in Q4 2021, according to the Lincoln Senior Debt Index (LSDI), which tracks more than 4,750 portfolio companies backed by private equity (PE) firms and private lenders.
The simultaneous drop in fundraising and uptick in default levels will present the first prolonged slowdown that some private debt managers have faced.
Private debt’s expansion during the last decade came as commercial banks stepped back from mid-market and acquisition finance deals to concentrate on rebuilding balance sheets following the global financial crisis. This enabled private debt funds and other direct lenders to step in and fill the liquidity hole left by commercial banks and become a source of financing for borrowers who could not secure funding from the commercial banks, allowing private debt funds to increase their market share and expand their assets under management.
Many private debt franchises have not had to navigate an extended downcycle in lending markets until now. According to Bloomberg, a number of debt funds are already moving to bolster their in-house workout and restructuring capabilities in anticipation of higher default rates and financial stress within their portfolios.
Borrowers keep watch
As private credit lenders have deepened workout team benches, borrowers are keeping a close eye on how debt funds are responding to an increasing number of borrowers encountering financial stress and distress.
To date, many private credit players have been open to supporting companies and PE sponsors by extending maturities and amending terms to help borrowers through periods of market disruption. The LSDI, for example, has tracked more than 450 amendments to loan documents through H1 2023, representing a fifth of the companies followed by the index.
Private credit players often rely on sponsor relationships for most of their lending transaction flow. According to Deloitte, PE-backed companies have consistently accounted for more than two-thirds of European private debt deals in almost every quarter over the past 10 years.
This is one of the reasons why private lenders have often taken a more conciliatory approach—sponsor relationships, a source of lending opportunities, have long-term strategic value for debt funds.
In addition, sponsors and private lenders frequently have aligned interests in distressed and restructuring situations. Sponsors will often want to buy time for companies with stretched balance sheets to stabilize, while lenders may not want to take control of multiple assets under pressure at the same time.
As a result, full-blown restructurings have been relatively rare. Instead, private credit lenders are using a variety of tools to protect value and maintain cooperative sponsor relationships.
According to the LSDI, most private debt default risks have resulted from interest rate increases rather than declining earnings, allowing borrowers and lenders to proactively address potential problems early and amend loan documents. When undertaking amendments, lenders have in some cases negotiated equity injections from PE owners or increased interest rate spreads, including the use of payment-in-kind interest structures where interest due is added to the principal balance of a loan instead of being paid in cash.
Markets may be tough, but many private credit lenders are acting pragmatically and looking to support borrowers through this period.