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Search for diversification begins as direct lenders predict uptick in defaults
by Kellie Ell
Private credit is the hottest asset class in the market, with the likes of Ares, Goldman Sachs and HPS raising tens of billions of dollars for new funds in the past few months. Meanwhile, new vehicles are opening the door for retail investors who now have access to an asset class that was once reserved for institutions.
But amid the buzz there are doubts. Headwinds, such as the upcoming US presidential election and uncertainty over interest rates, have caused the market to become cautious as competition increases.
In a recent report, Brad Bauer, Ilfryn Carstairs and Giuseppe Naglieri, the co-chief investment officers at Värde, said: “Confusion around the direction of monetary policy remains a key theme of the year.” They also explored the opportunity to serve as a credit provider in markets such as US home-building or in India, where the firm sees an expanding pipeline.
Greg Myers, group sector head, debt capital markets, at Alter Domus, wrote in a separate report that returns might start to tighten in private credit thanks to the return of the BSL market and banks regaining share.
“An uptick in private debt default rates would place a natural check on the rapid growth of the private debt industry over the last five to 10 years,” he said. “Bank retrenchment, low defaults and high yields have created a ‘goldilocks’ environment for new entrants, but as these favourable drivers moderate, a winnowing of the market is set to follow.”
Myers doesn’t see these factors as a disaster for private debt. “Direct lending activity remains robust and issuance has continued to grow through the course of 2024, but tightening margins do point to narrower yields in a more competitive market where private debt managers don’t have it all their own way.”
Others highlight that while high interest rates and growing defaults are challenging, they also represent an opportunity for better performing managers to differentiate themselves.
Diversification within private market allocations is crucial
Nils Rode
Chief investment officer
Schroders Capital
With some borrowers struggling to pay back loans, they will prioritise the cost of capital over flexibility in loan terms, Patrick Marshall, head of private credit at Federated Hermes, pointed out in a report.
“Different forms of borrower restructurings will increase, especially for those funds that have lent with aggressive loan structures to cyclical companies,” he wrote. “Some borrowers... will struggle to find liquidity to refinance their loans as they approach maturity, meaning that only the strongest and most stable companies will find it easy to access the market.” As a result, Marshall’s firm has seen “continued and welcomed growth of market share for conservative direct lenders in the European lower, mid-market”.
A report by Oaktree took a similar view. The asset manager pointed out that because so many wealthy individuals now allocate to the debt markets it has “put upward pressure on prices in most asset classes. This concentration of wealth has caused capital markets to be far more generous than would be expected in an elevated interest rate environment. As a result, many highly levered companies have been able to postpone potential problems by refinancing their debt.”
It’s no surprise, then, that both managers and investors are looking for new opportunities in private credit beyond direct lending, and beyond traditional institutional investors. Some popular niches include asset-based finance, SRTs, secondaries and infra debt.
Nils Rode, chief investment officer at Schroders Capital, is a fan of infra debt, insurance-linked securities and asset-based finance. In a report, he said he’s optimistic about tailwinds in the market, such as valuation adjustments, but acknowledged that ongoing geopolitical tensions play a role. “[That] means diversification within private market allocations is crucial,” he said.
