Private debt’s inexorable rise

Many industry observers expected the wider credit markets to be shut during much of 2023 as global interest rate rises took hold, and market sentiment was to anticipate sustained increases. Large-cap activity was at a historic low and we moved into the end of Q1 with the collapse of SVB and further financial sector disruption in Europe.

Within weeks, however, reporting figures signalled cooling inflation, and the possibility of a shorter period of rises pushed global equities to regain their March losses and finish the quarter at an even higher level. The financial sector quickly shrugged off the impact of SVB and Credit Suisse, believing it would not be a systemic indicator of the future.

The markets were coming back to life and, while the era of extremely cheap credit was gone, piles of dry powder in the asset class meant that private credit was very much open to conducting the right business when the M&A markets could better bridge valuation gaps to transact more readily.

Interestingly, these dynamics created pockets of confidence that a return to activity would quickly follow, but also a more muted optimism in other corners of the markets, expecting a much more cautious return to buoyancy.

European and US credit markets continued to pick up in Q2 alongside reducing recessionary concerns and increased GDP, though increased activity was not in the most obvious places. The more traditionally resilient sectors were not as active as expected, with underperformance in energy and communications, while technology (boosted by market sentiment around AI) continued to show meaningful gains despite sporadic concerns around inflated valuations.

Valuation dynamics themselves continued to permeate the private credit markets, as is typical and expected in more challenging macroeconomic conditions.

From extended diligence periods to judicious use of purchase price adjustments, buyers and lenders did what they could to limit the risk of getting it wrong with valuations. Both priced risk with considerable regard to relationships. Valuations and relationships have become two of the key themes of 2023. With some credit funds being decidedly less active, others stepped in to collaborate closely with sponsors and corporates to steal a march on existing relationships.

Many of today’s larger direct lending funds built their businesses when bank markets were inaccessible post-2008, and many funds used the recent period of dislocation to pounce on an opportune moment and build market share. We will not know for some time how effective this has been, but to see increasing activity levels despite the ECB raising interest rates twice in Q2 would make for an interesting summer.

Mixed bag

What then of Q3? A mixed bag. M&A levels showed meaningful signs of resurgence, with a number of mid-market deals completed, and the return of high-yield activity.

Interestingly, jumbo transactions have returned without use of the broadly syndicated markets, and clubs of direct lenders continue to dominate even the largest deals. While some players took the summer to take stock and build their pipeline for the rest of the year, others transacted quickly, and a relative glut of private credit transactions were papered over the summer months, more in the UK and US markets than in continental Europe.

The brief resurgence of traditional bank lending in the small and mid-cap space led to some speculation about the return of bank deals, but that has not yet taken hold, with bank risk tolerance on anything but low-levered credits in acceptable industries preventing any meaningful return to prominence. Global equity markets and government bonds declined, and commodities and energy responded to global production costs to rally against first- and second-quarter negativity.

This maintained a cautious atmosphere in the broader environment, sending what would have been a Q4 pipeline for some actors into the Q1 2024 pipeline. The fear of having incorrectly called the bottom of the market and invested too soon, with regard to pricing and valuation, has driven a number of investors toward an abundance of caution through the majority of 2023.

However, Q4 appears to have started brightly on the back of some large private credit transactions, with deals such as Constantia Flexibles reportedly undertaken by a single credit fund. Conviction around the right name signals that thoughtful risk appetite is very much evident.

The launch of a number of processes in Europe and the US is a good signal that market activity is increasing across sectors that had been relatively quiet versus positioning in the cycle, such as healthcare. The billing for 2024 looks even more busy when we consider the maturity of loans entered into during 2018 and 2019, and the fact that credits rarely leave it to the last year of the facility to engage in a refinancing.

Barring some unforeseen macro event, we can therefore expect a fervent 2024 for the private credit markets and, as we have seen in 2023, what may seem like major hurdles can quickly dissipate with limited impact. Equally, though, what may appear to be relatively innocuous events in a relatively small part of the global economy can have a sweeping effect on the ability to raise capital, or the willingness to deploy it.

The comeback

Looking forward to 2024, we can expect something of a resurgence in deal activity

For many investors, the aim has been to build their pipeline and focus on the right credit and risk profile for their strategy. The market will have also benefited from increased historic information on interest rates and more of a stable environment for determining proper valuation multiples. In addition, private credit saw a huge growth uptick from around 2018, which means there will be a significant number of private credit maturities to be worked through.

These factors should combine well to help drive healthy activity levels in the first half of 2024, but we should be mindful that there may be a considerable gap to be plugged by junior capital, as existing financings will require a high level of leverage relative to senior secured risk tolerance, and the prevalence of junior and holdco financings is likely to increase significantly.

Aymen Mahmoud is a partner and co-head of finance, restructuring and special situations at McDermott, Will & Emery in London, Riley Orloff is a partner in New York, and Ludwig Zesch is a partner in Munich