The private debt market 2023: Five things to consider

The challenges created by continued economic and market upheaval may have spilled over into 2023, but as is often the case in turbulent times, there are some bright spots to be found among the clouds.

From a private capital perspective, this year especially, it will pay to balance the need to make measured investment choices with the confidence to grasp the nettle when good deals arise. Here are five key areas for consideration today.

1. Seize the opportunity

In the current climate, as more companies come under stress, the market opportunity for special situations credit strategies is expanding. These are not necessarily businesses in severe distress, but ones that need to restructure in order to expand or as short-term ‘sticking plaster’ facilities offered during the pandemic come to an end. What they require now are longer-term, more permanent and flexible financing solutions. But banks may not be willing or able to take on new business or provide credit on suitable terms, creating demand for funds with capital to deploy to act opportunistically to meet this need.

2. Be pragmatic about interest rates

Conditions mean that fund managers are having to take affordability into account more than during more benign times, and there’s an impetus to move away from fixed interest rates towards floating rates. Due to the certainty they provide, fixed rates are understandably popular from an investor perspective, especially with private market investors, and they make huge amounts of sense for closed-end funds targeting fixed returns too.

But given where base rates are today, fixed rates have increased considerably, and it’s a big ask for corporates to commit to that level of interest over the term of a five-year facility. Even more so since there’s an expectation among many commentators that interest rates and inflation are now at or near the peak. With that prospect in mind, borrowers will doubtless increasingly be pushing for floating rates. Investors will need to weigh the options carefully.

3. Consider market dynamics and risk

Banks’ retreat from the lending market has left an opening for private credit funds to step in and fill the gap. However, while the opportunity set may have increased, so too has the risk. Investors therefore need to consider what level of return they expect as compensation for providing debt facilities to businesses, and for doing so on more flexible terms than were traditionally on offer from mainstream senior lenders.

This is not just about the headline interest rate: investors are increasingly negotiating for a nominal share of the equity to be included in the deal. By participating in the equity strip alongside the equity sponsor, the rationale is that providers of credit can benefit from some of the upside delivered by that credit. It’s a canny approach.

4. Think about structure

As an investor, looking at how funds are structured is vital in volatile markets. Managers of open-end funds may be put under pressure to sell good assets quickly simply in order to create liquidity for investors. In a worst-case scenario, if some investors get jumpy, they could trigger a snowball effect, prompting others to rush for the exit, whether justified or not.

We’re strong advocates of closed-end funds for long-term investments because the risk of an investor stampede to have capital returned is negated. Managers of closed-end funds therefore have the time and space to sort out any issues within the portfolio with no need for a fire sale of assets for no good reason. Investors’ returns are not subject to the whim of others.

5. Seek out differentiated strategies

It’s certainly not all doom and gloom at the moment: even challenging market environments can create the right conditions for certain strategies to perform. Different markets come to the fore at different times – hence the logic behind investing in differentiated strategies that capture the upside of major market trends while serving to increase portfolio diversification.

Venture debt is a prime example right now. Amid market dislocation, shareholders are increasingly opting to delay companies’ next major funding rounds until the outlook for valuations improves, requiring interim debt finance to keep the business ticking over in between. This calls for specialist lenders – it’s far outside the comfort zone of banks. For the moment at least, it’s a growing area.

2023 may continue to throw up challenges, but demand for private debt is strong. Private market investors who are open-minded and opportunistic, yet practical and level-headed, should be well placed to spot the best sources of returns and balance risk and reward appropriately.

Connection Capital is a London-based investment and advisory firm connecting private investors to alternative asset opportunities