The capital currently being raised in private debt, primarily in direct lending strategies, continues to reach new records, with Private Debt Investor reporting institutional private debt fundraising of $249 billion in 2021. When we combine this with the more than $30 billion raised by business development companies, more private debt capital was raised in 2021 than in any previous year. But why are investors attracted to the asset class?

As one of the largest players in private credit, Ares is keenly aware that institutional and retail investors alike are seeking premium risk-adjusted returns, high current income, lower volatility and lower correlations with more traditional asset classes. Over the past decade, private credit assets have produced superior total returns compared with other non-investment grade traded assets with comparable or better loss rates. Although data sources are not as available, we believe this is also the case for European and Asian private debt.

The increased capital inflows into direct lending have brought a heightened level of competition for transactions, and this has led to tighter pricing and reduced structural protections to varying degrees. That said, we believe risk-adjusted returns in direct lending remain superior to other traded asset classes. So, is more capital and greater competition necessarily bad for investors in the asset class? And what are the implications for the future?

Capital gains

Since scale is a competitive advantage in sourcing and underwriting private credit investments, capital is flowing to the largest managers. According to PDI and BDC data, more than 40 percent of the capital raised in 2021 went to the top 10 managers. We believe that larger private capital managers are benefiting from scaling their capital bases into new markets and opportunities.

Companies seeking $1 billion-plus debt financing can now execute privately negotiated transactions in lieu of the syndicated markets. We believe this addressable market expansion eases the capital deployment tension created by significant inflows. In 2021, per Direct Lending Deals, 27 private unitranche transactions in excess of $1 billion were completed with an aggregate value of $48 billion, up greatly from prior years.

The ability to routinely underwrite and hold $1 billion-plus transactions expands the opportunity for private credit, largely at the expense of public syndicated transactions. In fact, private capital providers have started to underwrite and commit to transactions as large as $5 billion. This means the largest capital providers can now service nearly all of the companies accessing the syndicated loan and high-yield markets.

The convergence of the public and private markets is not a binary one, as many large borrowers are also seeking hybrid public and private executions. Established managers with both liquid and private credit franchises are at an advantage in providing these solutions, which benefit borrowers who can be nimbler in their decision making between private and syndicated financing.

Despite increased competition and greater capital, the private credit landscape is evolving to benefit those with longevity, expertise and significant scale. Historically, the direct lending market was confined to smaller mid-market borrowers. Today, with the increased amount of capital raised by the large players, private credit managers have expanded beyond the mid-market and can invest in larger companies.

Borrowers see the benefits of private credit and significant inflows are driving the scaling of private credit into more established and experienced managers. This creates more choices for issuers and it provides investors access to increasingly higher quality, larger and more diversified companies.

Chris York is partner in Ares Management’s credit group; Greg Mason is a managing director for the firm’s public markets investor relations