Private Debt

Sharp moves in interest rates weighed on fixed income assets in Q1, with the Bloomberg Global Aggregate Index falling by 11% from its January 2021 highs. Subsequently CPI inflation hit 8.6% year on year to May 2022 – the largest 12-month increase since the period ending December 1981.[1] Inflationary pressure came from the energy component in particular, which rose by 34.6%[2] over 12 months – the biggest 12-month increase since September 2005. In addition Q2 saw a further move in the US 10-year Treasury, as the hawkish path the Federal Reserve was taking became clearer.

With further interest rate hikes seeming likely, we expect that private debt will attract more attention from traditional fixed income investors. Rising yields could broadly boost private debt fund performance, given that most private debt products are floating rate, so their valuations are less sensitive to rising rates. As it has been less directly impacted by central bank intervention, institutional investors are therefore turning to the private debt market.

Despite all the challenges, investors are happy with private debt. Our recent investor survey showed that investors continue to favor private debt for its diversification benefits and reliable income stream.[3] The floating rate exposure and downside protection it affords are key benefits.

In this research we discuss Preqin’s forecast for private debt. New for this year, we are forecasting performance, as well as discussing fundraising AUM. We will first consider the results at a global level, before drilling down into each of the major geographies: North America, Europe, APAC, and Rest of World. 

Private debt strategies are broken down into three buckets for modeling purposes: direct lending, distressed debt, and SS&MD (special situations and mezzanine debt). SS&MD are modeled together and can be thought of as higher-risk debt strategies.

Private debt global forecast

Preqin forecasts that private debt AUM will grow at a CAGR of 10.8% between 2021 and 2027 to reach an all-time high of $2.3tn in 2027 – a significant increase from the 2021 figure of $1.2tn (Fig. 3.1). With all alternative assets AUM growing at 9.3% CAGR, over the same period, private debt is gaining share overall.

Looking regionally, we expect AUM in North America to nearly double, increasing from $751bn in 2021 to $1.4tn in 2027 (Fig. 3.1). We forecast that direct lending will be the strategy with strongest AUM growth – growing globally at 14.8% to reach $1.2tn in 2027 (Fig. 3.2).

Driven by strong investor demand and solid performance, private debt AUM has already exceeded our earlier forecasts. In 2017 we forecast that private debt AUM would reach $1.4tn by 2023. In fact, our forecast suggests we may hit that figure a year early, before surpassing it to reach $1.5tn in 2023.

As an asset class, private debt’s performance is forecast to be slightly weaker than in the past. Between 2015 and 2021 private debt’s annual performance was 9.4%, compared with our forecast average performance in 2021-2027 of 8.4% (Fig. 3.6). We see a similar picture for each of the private debt strategies. Direct lending performance is forecast to be slightly weaker at 6.4%, similarly distressed debt (9.0%) and SS&MD (10.4%) are expected to slow.[4]

Compared with all the other private capital strategies we modeled, distressed debt comes out around the middle of the pack for forecast performance. As stated above, direct lending scores lowest for performance – although this is no impediment to investor interest! The reason is that direct lending offers floating rate exposure, shorter time to maturity and lower risk – especially compared with other private capital asset classes. Clearly, raw performance is not the only consideration for investors; risk and liquidity are also important.

Direct lending consolidates its lead

Direct lending is the largest strategy in private debt, and a key one for investors as it is most exposed to floating rates. As mentioned, we forecast direct lending AUM to hit $1.22tn in 2027 – more than doubling from AUM of $532bn in 2021 (Fig. 3.2). This represents a CAGR of 14.8%. There could be further upside to these growth numbers if rates in hikes are sustained.

Direct lending’s share of AUM will increase, as it is outpacing the growth of the broader private debt asset class. We forecast direct lending will increase to 54% of private debt AUM in 2027, up from 44% in 2021. This is no surprise, given we forecast returns from direct lending of 6.4% per year from 2021 to 2027. These returns are compelling for investors looking to preserve purchasing power, especially compared with publicly traded instruments where they have less control over lending conditions and covenants.

Distressed debt: Manager skill will be essential amid weakening fundraising

One of the most interesting data points to come out of our forecast is the fall in fundraising for distressed debt. Preqin’s data suggests annual fundraising increased on average by 12.3% per year between 2015 and 2021. We are now forecasting an overall reduction in fundraising, from $44bn in December 2021 to just $20bn by December 2027 (Fig. 3.9). The bulk of the reduction comes from North America, with fundraising there falling from $35bn to $11bn a year, over the same period.

Distressed debt AUM growth is forecast to slow, which is not surprising considering the stalling fundraising discussed above. We expect AUM to hit $297bn in 2027 (Fig. 3.2), a record high, but growing at just 1.7% per year between 2021-2027.

With the US entering a recession, distressed debt could benefit from investors’ reluctance to lend and lock up higher spreads to hold through the downturn. However, if done with skill, the ability to benefit from lower default, and higher recovery, rates means an opportunity exists for supernormal returns through manager skill. The returns remain relatively attractive, with distressed debt forecast to deliver solid annual performance of 9.0% between 2021 and 2027, practically unchanged to that realised in the period between 2015 and 2021 of 9.2%

It is worth bearing in mind that these figures are averages. With careful fund selection, allocators could benefit from further upside, given the potential dispersion in returns through a downturn and subsequent economic recovery. 

Higher risk strategies the strongest performers – as expected…

We group special situations and mezzanine debt (SS&MD) into one category (‘Other’) for our forecast model. These represent the higher risk private debt strategies and, as at December 2021, constituted 34% of the private debt universe (Fig. 3.2). These strategies are expected to deliver stronger performance than the asset class average, with annual average returns forecast to be 10.4% (Fig. 3.6) between 2021 and 2027, compared with 8.4% for the broad private debt asset class, over the same period.

We are forecasting AUM to hit a record $740bn by December 2027, growing at an average rate of 10.0% (Fig. 3.2) between 2021 and 2027 and only slightly lower than for private debt overall (10.8%) (Fig. 3.1). This is in line with annual increases in fundraising of 11% (Fig. 3.9), showing that capital is being deployed as it is raised. If at some point through the forecast period there is an economic recovery, especially in the US where most of these funds are based, we would expect demand would be stronger than forecast. This is tied to the interest rate cycle. As expectations of loosening increase, we expect investors’ risk appetite also to increase, making room in portfolios for the yield pick-up they would gain from strategies such as mezzanine debt.

North America leads the world for performance

North America is by far the largest geography by AUM for private debt and this is set to continue. We forecast private debt AUM in North America to reach $1.4tn in 2027, growing at 11.5% (Fig. 3.1) between 2021 and 2027. North America is set to outpace the rest of the world, with stronger AUM growth than the global average of 10.8%. The relatively strong economies of North America, driven by the United States, mean that asset allocators are still likely to favor the US over other geographies. Market depth, liquidity, and maturity are important in an uncertain macro environment. This drives our expectation that North America will consolidate its lead over other geographies.

Despite our strong AUM forecasts, we forecast North America to deliver annual performance of 7.8% (Fig. 3.6) over the forecast horizon, slightly lower than the global average of 8.4%. As investors favor the US, we expect dry powder to increase, which is likely to result in continued competition for deals. In our recently released Investor Outlook, we found that 74% of investors were happy with returns over the last 12 months and that they were most concerned by competition for assets and deal flow. These results are consistent with our forecast.

Increased volatility in public markets, especially with the significant moves in US interest rates, may encourage investors to consider private debt as a substitute for traditional fixed-income investments. As stated at the outset, direct lending’s significant floating rate component drives demand for the asset class. We forecast that fundraising for North America-focused direct lending funds will grow from $74bn at the end of 2021 to $110bn at the end of 2027, reaching a CAGR of 6.8% (Fig. 3.9). This will feed through into the strategy’s strong forecast AUM growth of 16.9% from 2021 to 2027 (Fig. 3.3). Across private debt as a whole, we foresee fundraising growth in North America being more muted at 4.9% (Fig. 3.8) in 2021-2027.

Unremarkable growth expected in Europe

Private debt AUM in Europe is forecast to grow at 10.0% annually between 2021 and 2027, to reach $636bn in 2027 (Fig. 3.1) – up from $359bn in 2021. In Europe, distressed debt is forecast to grow at 7.2% per year, to reach $98bn – up from $64bn in 2021 (Fig. 3.4) and quicker than the global average of just 1.7% (Fig. 3.2). Distressed debt has the potential to do well through a challenging economic environment, as this is the catalyst for the investment opportunities on which the strategy relies.

Nevertheless, we forecast direct lending will continue to dominate the AUM of private debt in Europe, growing from $209bn in 2021 to $415bn in 2027 (Fig. 3.4) and making up 65% of assets in the region by then. This is consistent with investors continuing to allocate away from fixed income and into private debt, particularly the lower-risk strategies such as direct lending. The potential for lower duration would also be attractive if the ECB’s hawkish stance continues into the forecast period (2021-2027).

Turning to performance, we see further evidence of distressed debt’s potential to grow. Performance of private debt overall in Europe is forecast to be 8.9% (Fig. 3.6) between 2021 and 2027, slightly stronger than the global average of 8.4% over the same period. Distressed debt in Europe is forecast to deliver returns of 11.5% (Fig. 3.7) between 2021 and 2027, up from 10.8% between 2015 and 2021. The differential of these returns is generally as expected, given the higher risk nature of the strategy.

Fundraising in Europe is forecast to grow at the slowest rate of all the major regions, with forecast annualized growth of just 2.6% (Fig. 3.8) between 2021 and 2027. With the war in Ukraine constraining economic growth across Europe due to higher energy prices, a reduction in investor appetite for the region is as anticipated. We expect appetite in Europe for higher-risk strategies in SS&MD to decline, with the amount of funds raised per year declining by an average of 4.5% per year in 2021-2027. Echoing the theme above, direct lending and distressed debt will see fundraising improve (Fig. 3.9), suggesting that where appetite in Europe exists, it will be for lower-risk strategies and/or where investors can see a clear recovery play.

Direct lending drives record APAC AUM

We are forecasting the APAC region to reach a new all-time high AUM of $116bn (Fig. 3.5) at the end of 2027, growing at an annual compound rate of 8.0% (Fig. 3.1) between 2021 and 2027. This is lower than the growth between 2015 and 2021, but still significant given the economic headwinds facing the region, including China’s continued COVID-19-related restrictions. When these are lifted, sentiment could rapidly change, bringing significant upside to our forecasts.

Performance for private debt in APAC is forecast to see CAGR of 9.1% (Fig. 3.6) between 2021 and 2027- stronger than the global average. If we drill down by strategy (Fig. 3.7), we see that this is driven by direct lending returns in APAC (Forecast: 10.5%) being higher than the respective global returns for the strategy (Forecast: 6.4%). SS&MD strategies mirror the private debt asset class overall, with return forecasts slightly higher than the global numbers.

With APAC’s smaller asset base, we expect to see a smaller pool of assets competing for deals and so the potential for higher returns. This is consistent with our performance forecasts. Investors may be able to get a better risk-adjusted return if they are willing to work with boutique GPs in the region that can source deals at attractive levels. It’s worth considering, especially as many portfolio companies will be earning their revenue in USD, potentially mitigating currency and funding risk.

Rest of World includes those regions not captured elsewhere, with the principal regions including Latin America, the Caribbean, Middle East including Israel, and Australia. The ROW region represents a fraction of 1% of total private debt AUM, and we do not forecast this to change. Given the low level of AUM this region will likely continue to be a source of hidden gems, overlooked by larger players. The potential opportunity for enhanced returns is borne out in our performance forecasts. We forecast ROW performance of 11.9% compared with 8.4% for private debt globally. The differential in returns is similar across strategies, suggesting that these geographies offer opportunities for enhanced returns in smaller, more niche markets that some may overlook.

Conclusion

With extreme volatility across bond and equity markets dominating headlines, we expect investor appetite for safer investments, such as private debt, will continue to grow. We note particular points of potential interest as investors consider their future asset allocations:

• Private debt overall will grow at a slightly slower pace to 2027, reaching an all-time high AUM of $2.3tn by 2027. Performance and fundraising will grow at a slightly slower pace than in recent years.
• Private debt beat our previous forecast for growth. In 2017 we expected AUM of $1.4tn by 2023, but now forecast $1.5tn.
• Private debt AUM growth will be strongest in North America, but fundraising will be strongest in Europe. We think it will be stronger than the past and stronger than the global average. We interpret this as North America having a more mature market, while Europe’s private debt space is still developing, with space to grow – especially as investors are considering the benefits of the strategy compared with lower-yielding fixed income investments in the region.
• Out of favor APAC will deliver strong returns for private debt. Performance forecasts are stronger than global average.

Private debt is maturing as an asset class, and we see that in a slight easing in the pace of AUM growth. The asset class is still in favor with investors, although fundraising will be weaker than the past but still outpace private equity, the biggest asset class within private capital, and real estate. Clearly, despite shifting macro risks, private debt investors are well placed to both shield themselves from potential volatility and achieve solid risk-adjusted returns.