This article is sponsored by Fidelity International
How would you describe the evolution of private credit as an asset class over the past decade?
We have seen tremendous growth in private equity over the last 25 years and the exceptional growth of private credit over the past decade has been directly linked to that, as well as to the regulatory aftermath of the global financial crisis driving bank retrenchment. We have also seen financial repression with a long period of low rates, which has driven strong demand for alternatives from investors looking for yield.
In Europe, direct lending assets under management have grown from approximately €4 billion in 2010 to around €250 billion in the third quarter of 2022. Average fund sizes have also grown by a factor of four from an average of €500 million to almost €2 billion.
There has been an element of first-mover advantage, where the first participants have benefited from LPs re-upping and building early track records. At the same time, direct lending has evolved from a mid-market focus to the upper mid-market and, more recently, into large-cap deals. That migration to bigger deals means direct lenders now face competition, not only from each other, but also from the broadly syndicated market and high-yield loans, while we see less competition in that mid-market space.
In previous periods of market stress, bank retrenchment had more of an impact on the availability of financing. Recently, direct lenders have acted as a bit of a shock absorber for the capital markets, taking down hung syndications and financing deals that banks were unable to support. As banks have stepped back, direct lenders have grown market share, while private credit has extended its reach into the CLO market and areas of specialist lending like non-performing loan strategies and significant risk transfers.
What have been the principal drivers of LP appetite for the asset class to date?
The risk-adjusted returns investors can achieve can be more attractive in the private markets, while private credit also offers diversification, allowing them to tap a huge chunk of economic activity not tied to the public markets. On the equity side, maybe the top 500 companies in the world are represented in most portfolios, while the private markets allow investors to access hundreds of thousands of smaller businesses with very attractive risk-adjusted returns.
Historical performance of the asset class has shown consistent returns with low volatility, while it has also performed well and proved itself through times of economic stress and market cycles.
Then there are the natural features of private credit: a predictable income with an attractive yield, floating rates that can mitigate the impact of a rising rate environment, and a lot of the market is either senior secured in nature or has strong diversified collateral, providing for high recovery rates in the event of challenges.
Because of its private nature, you don’t see the extreme movements evident in traded asset classes that are more liquidity-driven rather than fundamentals-driven. Plus investors like the risk profile, in the sense that you typically have investor protections in documentation and deals that are bilaterally negotiated with strong information flowing from borrower to lender.
Why has private credit proved so attractive to borrowers?
Borrowers like choice and some certainly prefer the public markets or syndicated loans because they offer a diversified capital base and a lower cost of capital, but they come with public reporting requirements. On the private side, you get a one-stop shop in most cases, dealing with just one lender. You are not going through a full underwriting process and then a syndication process, which delivers greater certainty of execution that has been especially relevant in volatile markets.
Speed of execution is a huge advantage, because the capital markets process eats up a lot of management time. And there is also much greater structural flexibility because a private credit manager can put a bespoke solution together.
Increasingly, private credit managers are gaining traction because they can deliver at scale and take down larger hold sizes meaning, overall, private credit can be a cost-effective and efficient alternative.
Which strategies do you expect to dominate over the next decade, and why?
The direct lending market has grown multiple times over the last decade, while various niche strategies have also evolved. Special situations and distressed will be a theme over the next few years and climate change is another big area where a huge amount of capital is needed to deliver on ambitious targets in infrastructure and renewables. Private credit can play a really meaningful role there.
The real estate debt market is also a significant area of growth. We are going to see more challenges with refinancing, because the adjustment in the rate environment means valuations will decline further and there will be more need for solutions provided by the private markets. That is especially true in the US given what is going on with the regional banks. There also needs to be a huge financing of the real estate stock because over 95 percent of buildings are yet to be upgraded from brown to green in line with environmental standards on insulation and energy efficiency.
More broadly, impact credit is going to be a big area, as are venture debt, speciality finance and private debt secondaries. We have seen a lot of activity around portfolios of secondary private equity, and credit is going to go the same way. Finally, we expect to see a lot more activity in Asia, as that becomes less bank dominated.
What will be the biggest challenges for managers in private credit in the next 10 years?
For more than a decade we have been in an environment of falling interest rates with a lot of central bank liquidity coming into the market. That created a situation where we saw strong performance and a very low cost of capital, allowing weaker companies to continue without too much difficulty because debt was cheap to service. Default rates have been low and private equity firms have been buying companies at ever-increasing valuation multiples.
The environment we are in now is very different and, with a rising cost of capital, companies may struggle to service their debt and PE firms may find they bought companies that will now not achieve the expected returns. We are going to have to go through a period of learning and we will see much more manager differentiation, which has been hard to illustrate through the benign conditions of the past few years.
The toolkit – meaning the skills, resources and expertise – required to navigate the conditions we are going into is going to be different to that needed in the last 10 years. There will also be additional resource challenges for managers taking time to deal with issues in their portfolios, who will find investing in new opportunities harder.
It is important to have the resources, though, because as valuations normalise it is in these markets that you see the best opportunities. Investors and managers have to be able to capture this vintage because we will see an ability to buy assets or lend at the right price with much better terms and at a much higher probability of a strong outcome for investors.
How is Fidelity positioning its business to address the maturing of the asset class?
Our USPs at Fidelity apply very much to our private markets activities, which are our global research capability, the strength we have on ESG and the strength of the investment processes we operate. Our goal is to have a long-term ability to offer both investors and borrowers compelling solutions across the market.
We have decades of experience providing investment solutions for public markets and increasingly our clients are looking for solutions in the private markets that we can deliver. Many clients are in fact looking for solutions that combine public and private exposures. We have a broad ability to meet those needs, both across asset classes and in terms of the infrastructure, technology, risk management, reporting and operational capabilities to respond to client requirements.
As we see democratisation of this asset class, it becomes increasingly relevant for large global asset managers to participate in this space as it matures. We will have an advantage in our ability to offer solutions across the public and private markets and to deliver diversification for investors. We are positioning ourselves as a manager that can offer that research advantage to those strategies along with a strong level of oversight and infrastructure.
How will the asset class evolve in its approach to ESG moving forward?
What we expect for private credit in ESG is the same as we expect for the broader markets. ESG will continue to evolve as the market continues to find ways to address sustainability risks and opportunities as part of investment processes.
Across both public and private markets, there is a growing risk that if someone does not focus strongly on ESG they will not be able to access mainstream public or private finance. If a borrower or investor does not have ESG integrated into their strategy, lenders will not gravitate towards those assets, and if a private equity firm doesn’t focus on ESG it will struggle to secure financing in the debt markets or sell a company at a profit. Managers that do focus on ESG will therefore achieve higher returns and gain traction with investors.
We are also likely to see democratisation of ESG-related data, with more accessible methods for measuring things like carbon emissions that will become more broadly available to investors and lenders. Over time we will see a more standardised and transparent approach, not just from companies but also from asset managers.