Private credit asset managers are confident that deal volume will pick up this year but say that there will also be more competition from the syndicated market.
“It's not an if; it's a when” is how a source working for a major private credit lender put it. Pressure from limited partners to return capital will help drive volume, and if general partners want to keep fundraising in 2024, they will need to show return on capital, the source said.
For investors holding on to see what will happen to interest rates, the recent Federal Reserve pivot from consecutive increases to admitting potential cuts in 2024 has set a positive outlook for deal volume in the next few months.
“What the Fed has done is given a lot of confidence to buyers and sellers and financiers. Confidence is what gets deals, and the market has gotten a lot of confidence in the last two or three months,” a second source working for a financial advisory firm said. “You’re starting to see that manifest itself in increased sell side and increased appetite to put money to work.”
Pent-up demand from a slow 2023 could also drive dealmaking this year. The aggregate transaction value for global M&A in 2023 was $1.83 trillion, with a total of 33,457 transactions, as of Nov. 1, down from $2.98 trillion in 2022 from 51,709 transactions, according to a recent S&P Global Ratings report.
“While overall leveraged buyout transaction activity remains below the post-pandemic highs, we have been seeing more demand for acquisition financing in our private credit business,” KKR said in a report signed by Christopher Sheldon, its co-head of credits and markets. The firm saw more public-to-private transactions in the first part of the year, but beginning in September it noticed an uptick in sponsor-to-sponsor transactions and nonsponsor activity. Those included “businesses that either chose to seize a moment of relative stability or simply couldn’t wait any longer,” the report said.
Private credit grew to $1.69 trillion in assets under management as of June 2023 from $1.47 trillion in December of 2022, according to data from Preqin. BlackRock projects the asset class to further increase to $3.5 trillion by year-end 2028, stating in its first-quarter 2024 report that as the asset class grows, so will its addressable market. That includes, first and foremost, private debt secondaries and private debt CLOs but also nonsponsor deals and partnerships with global banks.
More Competition
Increased competition from the liquid markets, which have been picking up, is reflected in a further tightening of private credit spreads, with the best-quality deals pricing between 500 to 550 bps over SOFR in the last month, sources said. That’s further down the roughly 100 bps drop that the market saw over the third quarter of 2023, as Reorg
reported in October.
For syndicated deals in the United States, average spreads came down to 485 bps at the end of November from a high of 546 bps in March, according to data from Morningstar cited in a Blackstone November
report.
Spreads for B3 issuers could potentially drop to the mid- to low-400s if interest rates start to fall. The Federal Reserve Open Markets Committee alluded to cuts in the effective funds rate in 2024, the source working for a major private credit lender said. In that scenario, cost savings will start to outweigh the uncertainty and headache of getting a deal done in the public market.
In the last two weeks of 2023, a third source, who advises clients in middle-market financing transactions, saw a handful of well-performing companies with private credit loans issued over the past 18 months poised to tap the broadly syndicated market in January for a refinancing.
Although that is anecdotal, it breaks from the trend of last year and may indicate upcoming ebbs and flows between the two sides of the market, that source said.
“From a lender’s perspective, banks are still providing far less capital than they once were, while capital markets seem to be slowly reopening, albeit in a jerky, one-step forward-two-steps-back pattern,” the KKR report said.
Pension Fund Allocations
Pensions funds, which are responsible for 70% of traceable capital within private debt, have allocated 6% of their current fund assets to private debt - an increase of 1 percentage point from a year earlier, according to a report from Bank of America published in October.
While part of that was initially due to the denominator effect, with public, more liquid investments falling faster and thus causing allocations to appear higher, that has “largely been mitigated” with the jump in middle-market premiums, the report said.
“Going forward, we expect private capital to remain sticky. As per industry surveys, most real money investors plan to maintain if not increase their allocations to alternatives next year,” the report said.
Among funds that have recently reviewed their investments policies to increase target allocation to private credit are the
Los Angeles City Employees’ Retirement System, or LACERS, (to 5.75% from 3.75%); the
NYC Fire Pension Fund (to 6% from 4%); and the
State of Wisconsin Investment Board (to 18% from 15% for private credit and equity), as Reorg has reported. The
Kentucky County Employees Retirement System is weighing a jump in specialty credit allocations to between 20% and 23% from its current 10% target.
“The expansion of the private credit program, based on attractive expected return assumptions, called for increased exposure into higher yielding strategies such as opportunistic or distressed lending to achieve improved portfolio yield and resilience under a variety of market conditions,” LACERS said in an agenda.
Defaults
As long-term investors that hold loans to maturity, private credit lenders often boast higher-quality underwriting practices, with better protections and closer relationships with their borrowers. While default rates are generally expected to go up, many private credit lenders maintain a somewhat optimistic tone.
“I keep expecting to see the quarterly numbers deteriorate from the portfolio, and I really haven't yet,” said Adam Wheeler, Barings’ co-head of global private finance, in a recent panel discussion about the 2024 outlook. “What we’re going to really see first is the impact of the interest rate on borrowers before we really see a decline in EBITDA.”
Default rates for private-credit senior secured and unitranche loans were around 1.41% in the third quarter, falling for the second quarter in a row, according to
data from Proskauer Rose LLP’s Private Credit Default Index. For companies with EBITDA above $50 million, however, it jumped to 1.2% from 0.8%. For companies with EBITDA between $25 and $49.9 million, default rate rose to 2.5% from 1.6%.
“We think it’s going to go to 3%. It could even go to 4%,” Benefit Street Partners President Richard Byrne said in a recent episode of The Reorg Primary View
podcast. “On a percentage basis, that’s a huge spike up, but from a historical perspective, it’s not at all. There have been many periods where default rates have been double digits … We’ve been operating with a default rate near zero.”
Bank of America expects that private credit defaults will likely reach 5% - well above broadly syndicated loans at 3%. A soft landing scenario, however, could result in a default rate of 4%, whereas a hard landing could trigger rates as high as 7% among middle-market companies.
“We expect headwinds related to debt service costs to remain a key issue in 2024, especially for the older vintages of deals that were underwritten in a more benign rate regime vs. the current backdrop,” BlackRock noted in the first-quarter 2024 report.
Performance will vary wildly between more and less disciplined investors, the Barings credit team agreed during the panel. “As cash flow becomes tighter and businesses start to underperform, I do think we will start to see quite a divergence in performance,” Wheeler said.