North America LPs target higher-return strategies as they increase private debt commitment plans

• 35% of North America LPs plan distressed debt commitments in next 12 months
• Increasing proportion of LPs targeting special situations
• Direct lending still largest strategy, making up 54.3% of North America private debt AUM

June 29 (Preqin News) – Increasing numbers of North America LPs are targeting private debt, with higher-risk, higher-return strategies featuring heavily in investors’ commitment plans for the next 12 months, Preqin data shows.  

Among the LPs that have disclosed their plans to Preqin, distressed debt is the most-targeted private debt strategy. 

The number of private debt strategy mandates recorded so far in 2023 is already up 131% on 2022’s total. Distressed debt is being targeted by 35% of the LPs that disclosed plans, ahead of special situations (20%) and mezzanine (18%). Direct lending remains the dominant private debt strategy, accounting for 54.3% of the $932.8bn North America-focused private debt  AUM, and is a named target for investment by 30% of LPs over the next 12 months. 

For most investors in private credit, allocations to strategies such as distressed debt, mezzanine, special situations, and venture debt allow for the addition of some higher-return exposure to portfolios, alongside less risky, lower-returning direct lending allocations. Within direct lending, demand for senior debt funds far outweighs that for vehicles focused on more junior parts of the capital structure, indicating that investors prioritize security from their direct lending investments.

The gap between the proportion of investors targeting distressed debt and targeting special situations funds has narrowed this year, from 24% in 2022 to 15% in 2023 YTD. The data points to an emerging disconnect between fund availability and investor demand. Preqin  tracks 68 special situations and 63 distressed debt funds currently in market with a North America focus, though the $30.6bn targeted by those special situations funds is dwarfed by the $55.1bn sought by distressed debt funds.

So why, given the challenging economic and interest rate environment, might LPs now be less focused on distressed debt? It does not appear to be for lack of opportunity. Dry powder for North America-focused distressed debt funds has fallen from a high of $70.3bn in December 2021 to $42.5bn in June 2023, despite three bumper years of fundraising in 2020, 2021, and 2022, when a combined $78.1bn was raised.

Investors may see distressed debt as a risk too far, particularly given rising inflation and interest rates. Most economic forecasters expect the US economy will continue to struggle through 2023 and into 2024. According to the Federal Reserve Bank of Philadelphia’s second quarter survey of professional forecasters, GDP growth is expected to slow from 1.3% in 2023 to 1% in 2024, a revision to the previous 2024 forecast of 1.4%, before recovering to 2.4% in 2025. The latest survey also adjusted expectations of headline CPI to 3.4% in 2023 from 3.1% previously. 

The broader special situations remit gives GPs the flexibility to tackle challenging situations, but also to take advantage of other opportunities, such as reduced competition from tighter liquidity in the debt markets more broadly.

- Grant Murgatroyd, Head of News at Preqin, contributed to this article.