Market Views: Is a bubble brewing in private credit?

Rising interest rates and slowing economic growth could put put the squeeze on borrowers and lenders. AsianInvestor asks how asset owners should assess that risk for private credit markets.
Market Views: Is a bubble brewing in private credit?

Asset owners have been increasingly turning to private debt amid public market turmoil, concerns about private equity valuations and a rising interest rate environment.

It's a rapidly growing segment: The global private credit market is now estimated at $1.5 trillion, up from about $440 billion a decade ago, according to alternatives data provider Preqin.

Asia Pacific-focused private credit assets under management are expected to reach an all-time high of $115.9 billion by the end of 2027, representing a compound annual growth rate (CAGR) of 8% between 2021 and 2027, according to Preqin.

However, there incredible demand for private credit is beginning to worry some veteran investors.

Co-founder of Oaktree Capital Management Howard Marks recently warned that the increase in private credit allocations might soon show its robustness – or lack thereof – when higher interest rates and slower economic growth put pressure on companies.

These portfolios have not yet been tested for challenging condtions and have only seen markets going one way - up, Marks said in a Financial Times intervew.

AsianInvestor asked industry specialists whether there is a bubble brewing in private credit markets given the tremendous interest from investors and what asset owners should be mindful of when they invest in private credit markets.

The following contributions have been edited for clarity and brevity.

Scott Baskind, CIO and head of global private credit

Scott Baskind

Significant tightening of financial conditions during 2022 and the “long and variable lags” with which monetary policy filters into the real economy lead us to anticipate that much of the economic damage from the Fed’s inflation fight will materialise in 2023.

As we consider the risks of default/credit loss in 2023, we are encouraged by the relatively healthy credit metrics in the market.

The share of issuers facing imminent liquidity challenges with respect to their interest cost burden is manageable.

Further, the tightening of monetary policy and prospect of broader US economic challenges that have characterised the broader market over the last several months have provided a backdrop for continued conservative lending structures and protective documentation.

However, over the next few years we anticipate that there will be idiosyncratic opportunities for catalyst driven credit investing as a broader slow-down will create opportunities to invest in “good companies” with over-leveraged balance sheets.

Yoon Ng, principal at global asset management advisory

Yoon Ng

While 2021 capped a period of strong fundraising across private markets, private credit bucked the trend with total fundraising of $205 billion by November 2022 versus $216 billion in 2021.

Looking ahead, while private credit is not immune to inflationary pressure, rising rates and increasing risk of defaults – especially in the event of a protracted recession – the private or concentrated nature of its business could lend well to re-negotiation of lending terms which can help corporates better ride through any cash crunch.

When investing in private credit markets this year, two factors are key when selecting private credit managers.

Firstly, size matters as larger private credit managers are better capitalised and more well-diversified to mitigate risks of slowdown or defaults in particular segments of the market.

Next is to ensure managers have strong primary due diligence capabilities, as in deals that are structured with favourable covenants, and can exert additional control over investment outcomes.

Gary Leung, head of alternatives for Asia Pacific clients
J.P. Morgan Asset Management

Gary Leung

When traditional lenders like banks tightened their lending standards after the global financial crisis, several alternative lenders including private credit emerged to fill the void, especially in the middle-market segment.

Direct lending has grown rapidly.

Since 2008, dry powder increased by 11-fold to $202 billion as of April 2023.

The economic environment in the last 1.5 years drove an increase in refinancing, leveraged buyouts and acquisitions.

With increased competition to deploy a growing stack of dry powder, we have seen more covenant-lite loans being extended.

It is worth noting that private credit default rate crept up from its low of 1% in September 2021 to 2.1% in December 2022.

Going forward, investors must navigate private credit carefully, as private credit managers need to balance between competitive loan extension and effective protection to minimise defaults amid market uncertainty.

The new interest rate regime also means a change of investors’ return requirement.

We see opportunities in private credit secondaries arising from denominator effect, and private credit special situations given liquidity shortage in specific parts of the market.

Ability to structure bespoke transactions will be key to navigate through this market environment.

Andrew Dennis, head of private placement research

Andrew Dennis

Agents and brokers often present deals claiming that the terms are “take it or leave it”.

Our experience is that this is seldom really the case and that assuming that one can’t ask for additional things is a mistake.

Asking for additional items such as additional disclosures or covenants are often gladly accepted by borrowers.

The ideal time to make requests is before a deal is closed, as following closure, they can be a less smooth process.

There can be a risk then that as some deals turn into bigger projects,  there may be a sense of wishing to see things through to some sort of successful completion, resulting in a Stockholm syndrome effect.

A strong governance process that focusses objectively on documentation and credit, structuring and pricing risks is essential.

It can be painful to step back from a deal, but ultimately this is what putting clients first demands.

Over long periods, many things can change including borrower profiles and economic conditions, and it is important to keep monitoring borrowers, with regular periodic updates.

Staying in touch with borrowers during the pandemic period proved invaluable for both sides. By working collaboratively with borrowers and their shareholders, we were able to help them and reduce the risks for our clients’ capital at the same time.

Shane Forster, head of Asia Pacific private finance

Shane Forster

Asian private credit markets have recently shown strong growth, albeit from relatively modest levels, as public and banking markets remain constrained, and borrowers become more accustomed to the benefits of private debt.

The outlook for private credit remains strong although the asset class will be tested by the higher interest rate environment and slowing economies.

Investors in the asset class should be focused on seasoned managers who have performed through previous economic cycles due to sound underwriting standards.

Such managers are well positioned to benefit from the strong returns currently available, while appropriately structuring investments to include significant equity buffers, maintenance covenants and robust security.

Investors should also be focused on the sub-segment of private debt that potential mangers focus on.

Portfolios that are exposed to developing markets, while typically targeting higher returns, are also exposed to heightened risks and asset quality will be tested in a subdued economic environment.

Conversely, managers focused on developed markets such as Singapore and Australia, while targeting lower annual returns in the 8-12% range, are expected to perform better in the current environment and offer investors relatively stronger risk adjusted returns.


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