Private debt: A steady ship in choppy waters

As the global economy emerges from the covid-19 pandemic, institutional investors are trusting private credit to provide high-yield, stable solutions.

Although 2020 was a turbulent and devastating year for many, it was an interesting case study on the strengths of the private credit market compared with other debt and credit investments, and laid the foundations for why private credit remains an important part of a private market portfolio in 2021.

Last year was marked by extreme volatility – especially evidenced by dramatic swings in liquid markets – yet private credit lived up to its reputation and provided much-needed consistency and steady cashflow. Following the coronavirus-induced shutdown in the second quarter, conditions in the private credit market were quite favourable in the third and fourth quarters, allowing well-positioned investment managers to seize numerous opportunities.

For lenders with few credit problems and some dry powder, the unusually attractive investment environment between April and the end of summer likely served as one of the best windows of opportunity in almost a decade. The fourth quarter then saw an explosion of transaction activity, with deal volume exceeding pre-pandemic levels. Many of the lenders that had been previously sidelined were able to return to the market in Q4, creating an increasingly competitive private credit environment. The remarkably high volume of dealflow was more than able to maintain favourable conditions, despite increased competition.

Stress tested

Last year, despite everything, clearly bolstered private credit’s credentials as a reliable alternative in such an unpredictable environment. So, what makes private credit so uniquely suited to withstand turmoil and volatility, and why does it remain important in 2021?

A key facet of private credit’s success is its relative stability amid times of uncertainty. Liquid credit, for example, tends to be significantly more affected by market technicalities that can overwhelm the fundamental changes in the underlying credits, especially during periods of severe disruption.

Conversely, private credit is more fundamentally driven and generally less affected by market technicalities  because it is typically held in lock-up vehicles that are not actively traded. Additionally, private credit deals also tend to employ less leverage and possess more equity, which helps contribute to their overall stability.

Low default rates are another key benefit of private credit. Leveraged loan default rates in the second and third quarters were as high as the levels seen during the global financial crisis; and at the end of the fourth quarter, the leveraged loan default rate remained high at 4.22 percent. By contrast, private credit default levels never rose above 2 percent throughout 2020.

As we make our way through 2021, there are several reasons to be optimistic about the private credit market. The vaccine rollout and additional economic stimulus are certainly positive indicators – we have seen many businesses already successfully adapt to this environment. Additionally, now that we are in the second year of the coronavirus pandemic, we have been inspired by some businesses’ remarkably successful attempts at adapting to new, changing circumstances.

There also exists a high level of dry powder in private equity funds, which will serve as a source for supporting existing portfolio investments, as well as help drive robust dealflow.

At the same time, there are some obvious challenges. Unemployment remains high, with a slowing rate of decline. Additionally, while restrictions are easing, we continue to see the spread of covid-19 and its variants in some places. And finally, we could very well still see rising default rates later this year.

Despite these very real challenges, the US’s current situation has us optimistic for a robust economic recovery this year, and we think that the private credit space is particularly well-positioned for the current market environment.

The Federal Reserve’s unprecedented actions – which included pushing interest rates to near-historic lows, exacerbating the demand for needed yield – have made private credit yields popular and will likely continue to do so through 2021.

The chart below depicts yield levels in 2020 compared with the available alternatives. Private credit senior loans – the most basic type of private credit investment – have a yield of about 7 percent, or approximately 200 basis points above the other fixed-income classes. Thus, we believe private credit continues to be a comparatively compelling option in the market this year.

Supply-demand imbalance

The record amount of private equity dry powder and a strong future pipeline for debt refinancing activity represent a forward debt demand of about $1 trillion in the next three to five years, with around $105 billion of private credit dry powder. This creates a 10-to-one demand/supply imbalance.

The mid-market represents a substantial amount of that deal activity and so, even if that number is cut in half, there would still be a significant imbalance favouring private credit lenders.

This supply/demand imbalance has preserved the premium that private credit lenders have been able to charge for almost 25 years.

Private credit lived up to its reputation as a stable source of reliable cashflow during a volatile 2020, and we are confident in its ability to remain a strong investment opportunity throughout 2021. As investors largely struggled with turbulence in the liquid markets, private credit served as a steady ship in choppy waters, and we believe it will remain a valuable part of an investor’s portfolio this year.

As we look ahead to a sustained period of low federal interest rates and a slow but positive economic recovery, many of the same conditions that helped private credit succeed in 2020 – including a favourable supply/demand imbalance – still ring true.