AFTER the rout in stocks and bonds in 2022, interest in private markets and other forms of alternative assets has been intense. On many counts, such assets have a role in portfolios. They offer the potential for higher returns than public markets. And, correlations with traditional assets are also low. Among such assets, private debt or credit has risen in prominence – to the extent that some observers reckon 2023 may mark the start of a so-called golden age for the asset class.
Fundraising in the years 2021 and 2022 was robust. On hindsight, that isn’t surprising. Investors were drawn to the benefits of a floating-rate investment as the United States Federal Reserve rapidly hiked interest rates. The momentum appears to have carried into 2023, despite the US’ regional banking crisis.
Data provider Preqin estimates that, as at the third quarter, private debt had raised some US$152 billion in assets. By end-2023 – with the fourth-quarter numbers still unavailable – fundraising could exceed US$200 billion or even surpass the US$215 billion raised in 2022. “This would be notable, given the volatility we have seen in fixed-income markets,” said Preqin.
Total assets under management (AUM) in private debt was estimated at US$1.5 trillion as at the third quarter. Preqin expects this to nearly double to US$2.8 trillion by 2028. BlackRock is even more optimistic; its AUM forecast is US$3.5 trillion by 2028. It said that this projection “may appear large at first glance, but is relatively modest in the context of the global financial ecosystem”.
Inflows are expected to be robust. Companies still need financing, and restraints on bank capital are a structural underpinning for private debt. On their part, investors are hungry for yield. But, what’s the catch? Recently, Julius Baer announced its exit from the private debt business following steep losses from loans made to real estate group Signa, which collapsed under the weight of higher interest rates. Julius Baer’s experience reflects some pitfalls that may easily be glossed over in the chase for yield.
The big question is surely the credit quality of private borrowers, as well as the value of assets that may be used to back the debt. The US economy has been resilient so far, but credit conditions remain restrictive. Default rates are expected to rise to 5 per cent. Rate cuts by the US Fed – now widely expected to begin in the middle of the year – will bring relief to borrowers and raise asset values. Even so, the quantum of rate reductions remains uncertain. Stubbornly high inflation could stay the Fed’s hand.
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S&P Global believes that “even moderate stress could diminish the credit quality of private credit borrowers”. Already, companies’ interest coverage ratio, as reflected in a senior debt index, has deteriorated. According to S&P, funding costs of smaller borrowers are approaching 10 per cent.
Regulators are surely vigilant for any signs that private debt could cause instability in the financial system. The International Monetary Fund has warned of vulnerabilities for institutions such as insurance companies and pension funds, which own private debt. But the Federal Reserve believes that the financial stability risks from private credit funds are low. This is because investors are required to lock up their funds for a long period, reducing the likelihood of panic selling.
For now, private debt assets will surely grow. But, investors should remember that there is no free lunch. With credit risks elevated, yields in private debt are attractive for a reason.
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