The past year in private credit has been marked by persistent inflation, rising interest rates and an economic backdrop of widespread uncertainty. Fundraising and deal doing are down with a notable slowdown in M&A activity from private equity funds, whose health has come to be closely linked to that of the direct lending market.

But there are some positives to take home from this year. Loss rates have remained fairly low, though they are rising, and investor demand remains strong, though the denominator effect continues to take its toll on fundraising efforts. Once again, the biggest firms have tended to be the biggest winners in the past 12 months. Average fund sizes crept above $1 billion and a number of big hitters raised substantial sums in 2023 despite the lower overall total.

Private Debt Investor spoke to professionals in the market to get their highlights of the past year.

Inflation and rates

Inflation has remained persistently high through 2023, especially in Europe. After initially spiking following the end of most covid-19 restrictions around the world, what was hoped to be a short term phenomenon has proved to be more stubborn. The war in Ukraine is about to enter its third year, still having knock-on effects for energy and vital food supplies, with a particularly acute affect on Europe.

As a result, much of the year was characterised by interest rate rises in key jurisdictions to try to tame inflation. Rapid rate rises brought an end to a long era of near zero rates seen across much of the Western world since the global financial crisis.

“The year was marked by aggressive rate raising and as a result a lot of M&A deals have been paused or are being revisited. In our view, this has led to a delay in new platforms coming to the market,” says Kevin Prunty, senior managing director at newly founded credit manager LongWater Opportunities.

While high rates are helping to bolster the returns achieved by credit funds, they have also made it more expensive to leverage private equity transactions, which has slowed down market activity considerably during 2023. However, there are still some deals taking place.

“The add-on space is very different, however, in that deals are generally smaller. Our belief is that this has made the space very active right now, with a lot of credit available,” Prunty adds.

James Keenan, CIO and global head of private debt at BlackRock, echoes these sentiments, and says: “It’s an uneven picture, while dollar value of M&A is down around 40 percent year-on-year, transaction volumes are down far less among SME deals, which is where credit funds are most active. A lot of SME businesses are looking to take advantage of lower equity prices to make strategic acquisitions and grow their business.”

But market volatility and uncertainty are also resulting in more firms needing to take action to restructure their loans in order to survive these tough conditions, according to legal experts.

Mike Mezzacappa, co-head of the private credit group at Proskauer, agrees that the slowdown in private equity is taking its toll, but also points to a growing need for financial sponsors to renegotiate their financing.

“The past year has been a bit of a mixed bag. Private credit lenders have been very active in whatever private equity transactions have been taking place, but the private equity market has been much slower than in recent past.”

Banks back in retrenchment mode

While the dynamics are very different from those of the GFC, we’ve seen a similar tale regarding bank lending, which is once again becoming scarce. Bank regulation introduced since the GFC means that for many, the cost of capital for lending to private markets deals is simply too high, while the regional banking crisis in the US in the spring has further limited the availability of bank finance for SME borrowers.

“Banks today need to deleverage. They hold around $23 trillion of debt assets in the US and about $29 trillion in Europe,” says Keenan. “Even a relatively small deleveraging among the banks could mean there is trillions of dollars of addressable market for alternative lenders and institutional capital.”

The period after the GFC was critical for bringing alternative lenders into the mainstream as banks reduced their lending. This new wave of bank tightening is likely to further accelerate the asset class as a growing number of corporates come to alternative lenders in the future, according to Angelo Gordon’s head of structured credit, TJ Durkin.

“Speciality finance companies are already looking to diversify away from the securitisation market as it is not reliable compared to what private credit managers are doing,” he explains.

Fundraising falls

Despite the relative optimism that private credit firms will be able to prove their worth in these tough market conditions, the fundraising picture for credit firms is more challenging, especially in Europe.

Data from PDI’s Q3 fundraising report shows that fundraising for the first nine months of 2023 was down 21 percent compared with the same period in 2022 at just $150 billion worldwide – the lowest comparable figure seen since 2016. A little more than half of this capital was raised by strategies focused on investing in North America, while European fundraising languished at just $32.7 billion in the first nine months of the year.

“We’ve seen this year that the denominator effect is very real and in our view, it is limiting the ability of LPs to invest in the private investment space, despite their considerable interest,” says Prunty. “We’ve also seen slower exits from private equity funds, which is further restricting the LPs’ ability to deploy capital in credit. However, as rates remain high, we believe LPs will continue to be attracted by the prospect of a PE-like returns at a lower risk in the credit space.”

While this has been a challenging year for lenders, clearly market turmoil is likely to benefit the asset class in the long term and we will be taking a closer look at what’s in store for 2024 in our feature tomorrow.