The private debt market has enjoyed a very strong period of growth and this momentum will carry through 2018 and beyond. The question is whether the growth posted in 2017 and prior years will be on the same trajectory or flatter?
Last year delivered another strong set of results for the private debt market and investors now have an unprecedented number of funds and strategies to choose from, catering to a wide range of risk/return profiles. But looking ahead, competition from traditional lenders could cool the private debt sector, with other headwinds blowing hard – including rising global interest rates.
Private debt has been one of the biggest success stories to emerge from the global financial crisis as opportunistic managers filled the vacuum left by the retreat of the traditional banks.
The fact that private debt is now clearly viewed by investors as a standalone asset class is also significant, as evidenced in the Intertrust 2018 survey. We believe this is driven primarily by the move from mezzanine debt towards direct lending, which brings with it a raft of direct regulations and keeps the asset distinct from equity classes.
Intertrust’s 2018 Global Private Debt Market report – based on a survey of 80 private debt and private equity professionals – found that the wider narrative is still relatively bullish: almost two-thirds (63 percent) of professional investors expect the private debt market to grow over the next 12 months, up from 60 percent in last year’s survey. Of these, a fifth (21 percent) expect a “significant” increase over 2018.
One of the major discussion points to come out of this year’s survey was the depth and scope of the competitive threat traditional banks pose to the private debt industry. This could be one of the key challenges in 2018/19 as rates inevitably creep upwards and banks decide whether to re-enter the market. A further consequence of rising rates is the increased risk of large default events for private debt funds across their portfolios.
The growing threat from traditional banks?
The challenge for the private debt sector is that cheap capital has meant lenders – often with deeper balance-sheet strength – can offer relatively competitive terms. If traditional lenders decide to lend more, the impact on the private debt market could become more material.
‘Balance-sheet strength’ and ‘competitive borrowing rates and conditions’ were cited as the most significant long-term advantages that traditional banks have over private debt managers – by 64 percent and 62 percent of respondents to the Intertrust survey, respectively. Other advantages were monitoring resources (55 percent), loan origination infrastructure (48 percent), the experience of teams (42 percent) and an ability to adapt to changes in the debt cycle (37 percent).
There are, however, signs that private debt funds could maintain their position even against a resurgence of traditional lending. Debt funds are increasingly seen as ‘Plan A’ money as banks’ appetite for some risks is diminished, particularly in those asset classes where there is limited traditional security.
Even when banks are committed to providing debt, they are increasingly partnering with debt funds to share the risk, and this is a trend that we believe may be permanent. Another growing problem for UK banks in the direct lending arena is that they have reduced relationship coverage in regional areas and so their dealflow has diminished to a significant degree.
This year’s survey also asked about the resilience of the private debt market against a rate rise of between 0.5 percent and 1.0 percent in 2018. Many commentators believe that most major central banks will either tighten or remove support in 2018, led by the Federal Reserve in the US.
Resilient to rate rises
The good news is that the majority (79 percent) of respondents believe the private debt market is resilient to rate rises – with 9 percent saying the sector is ‘extremely’ resilient and 55 percent saying it is ‘moderately’ resilient. Just 12 percent said they thought the market will not be resilient.
One interesting area of discussion is what will happen if the global financial recovery fizzles out. While many commentators are forecasting a strong year for global growth and economic activity, others are less bullish. If the economic recovery loses momentum, distressed fund managers may be well-positioned to take advantage of current overly lenient terms.
It is also widely believed that regulation will continue to have an impact on the sector. According to the research, respondents see regulation as the biggest challenge facing the direct lending market over the coming years – but more sensible regulation (i.e. of the lending, not the lender) would, in our view, be a positive development for the sector.
It will also be interesting to see how different countries evolve domestic regulation of the private debt sector as it continues to grow.
The future of the private debt market
Short-term fundamentals in private credit markets may be weakening. Credit spreads are tightening, signalling that investors are prepared to climb the risk curve without a corresponding increase in return expectations.
Notwithstanding this, the drivers behind the sector’s extraordinary growth remain largely in place, fuelled by global economic and GDP growth. In the current market environment, the 6 percent to 8 percent yield offered by private debt is considered a healthy, low-risk return, and continues to attract managers from more liquid asset classes. Fuelled by growing investor demand and macro-economic tailwinds, the sector has evolved into a sizeable, influential asset class in its own right.
Private debt managers should look forward to another strong year, albeit in an environment of increasing competition. The underlying strength of the global economy will play a significant role in shaping the competitive lending landscape and, therefore, the opportunities for the private debt industry in 2018.
Paul Lawrence is global head of fund services at Intertrust, the Amsterdam-based trust, fund and corporate services business