Those in the equity markets who subscribe to the ‘sell in May and go away’ approach may find some of their counterparts from the private debt world joining them on the beach this year.
June 6 (Preqin News) – Those in the equity markets who subscribe to the ‘sell in May and go away’ approach may find some of their counterparts from the private debt world joining them on the beach this year.
Ongoing uncertainty over the timing and outlook for central bank interest-rate action is helping to sustain a lull in private credit activity, some market participants say. Absent clarity over the direction of rate-setting, particularly when central banks might call time on their run of record rate rises, means the quiet spell that has prevailed since the start of the year will likely continue.
“A lot of investors are now going to take a long summer break,” said Fenton Burgin, Debt & Capital Advisory Partner at Deloitte. “Until very recently, the market anticipated that central banks in both the US and UK were approaching the peak of the interest rate cycle. After the last couple of weeks, people are contemplating further interest rate rises. And in that environment, buyers of businesses are saying to us: ‘Until I can really understand what my cost of debt is likely to be, it's very difficult to price deals’."
Private debt fared relatively well through last year’s turbulence but got off to a slower start in 2023 as investors and managers waited for more clarity on interest rates and economies. As rate-setters continue to contend with surprise data releases, expectations about precisely when central banks may choose to halt their rate tightening cycle have been pushed further down the road.
Slowdown in momentum
After three record-breaking years, private debt fundraising has slipped back to pre-pandemic levels. Preqin recorded 54 fund closes and a total of $63.9bn capital raised in the first five months of this year, down from $216.0bn by 244 funds last year. Average fund size increased from $1.0bn in 2022 to $1.4bn in 2023 YTD, boosted by mezzanine funds from HPS Investment Partners ($17.0bn, launched 2021), Goldman Sachs Asset Management ($11.7bn, 2022), and Crescent Capital Group ($8.0bn, 2021), the three largest funds closed this year.
Fundraising momentum has also slowed, a sign that the balance of supply and demand may be tilting. While the average number of months to final close is down from 32 in 2021 to 23 this year, it remains above the pre-pandemic average of 18. The average percentage of target size at final close this year is 95%, down from 102% last year and 118% in 2021. Aggregate funds raised exceeded aggregate target sizes in eight of the 10 years from 2013 to 2022.
The latest Federal Open Market Committee (FOMC) minutes revealed that officials were divided over the need for future tightening at their last meeting, split on whether enough has already been done to contain inflation (permitting rates to stay where they are), or whether more needs to be done to rein in price acceleration. In a development likely to add fresh uncertainty about next steps, Friday’s US jobs report revealed a surprise print of 339,000 new jobs in May, supporting the views that the US economy can accommodate further tightening.
Meanwhile, on the other side of the Atlantic, bets that the Bank of England would temper its tightening went awry when inflation data again confounded analysts’ expectations, prompting a swift re-draft of the yield curves. And expectations that ECB tightening could be coming to an end were cast into doubt this week when Joachim Nagel, President of Deutsche Bundesbank, was reported as saying further hikes would be necessary to tackle inflation.
‘Muted market activity’
Preqin data shows 164 deals with a combined deal value of $6.4bn in the first five months of 2023. This is a big fall from $99.2bn across 460 transactions in the first five months of 2022 and $110.0bn across 647 over the same period in 2021. It comes with a caveat that private debt deals are often not reported until GP and LP quarterly reports come in, so the numbers for 2023 YTD are expected to rise.
“Valuation considerations mean equity owners are holding onto their best assets for longer, and the volume of high-quality opportunities in the market has been curtailed,” said David Ross, Head of Private Credit at Northleaf Capital Partners. “We’ve been more discerning about the investments we make, but at the same time, we really haven’t had much roll-off in our portfolio because of muted market activity. Typically, in private debt, you are making new loans and replacing loans that have been refinanced, but lately, we have seen loan durations extend.”
While markets factor in cuts toward the end of this year and into the next, stickier-than-expected inflation will likely take longer to return to levels deemed acceptable by central banks, leaving interest rates higher for longer and threatening turbulence in other financial markets.
“The high interest rates, persistent inflation, and uncertain economic outlook dominating headlines all feed into the inherent strengths of private debt,” Randy Schwimmer, Co-Head of Senior Lending at Churchill Asset Management, said. “Its characteristic stability in the face of public equity and credit volatility will remain. Senior debt, being a floating rate asset class, will continue to be beneficial as a hedge even if rates moderate in the next several years.”
Private debt a 'must have'
While the ultra-low interest rate environment helped spur the development of the private debt market, a shift to a higher policy rate regime is unlikely to undermine longer-term interest in the asset class. According to the Preqin Investor Outlook: Alternative Assets, H1 2023, nearly two-thirds of LPs surveyed said they planned to increase allocations over the long term, the highest proportion since 2016.
“There seems to have been a shift from private debt being a ‘nice-to-have’ addition to your portfolio, to a ‘must-have’ core allocation,” said Churchill’s Schwimmer. “Investors better understand how private debt works and how to find the best managers with the best teams and track records to produce strong performance across all future cycles. As one large pension plan manager told us recently, ‘Private credit is the only bright spot in asset allocation right now.’”
Private debt has now firmly established its place in the asset allocation mix, but threats to its continued growth remain. First is liquidity in the financial system, where a continued retreat from longer-term lending by banks could impact the availability of subscription lines for private debt managers, hitting their ability to boost returns with an additional layer of leverage.
Second is the performance of companies and their ability to meet increased repayments. “Private debt has had positive message around increases in interest rates, which have not led to materially negative evaluations of existing portfolio of assets because of the floating rates,” said RJ Joshua, Head of Private Debt in Preqin’s Research Insights team. “But if this continues and we see higher interest rates, businesses will not be able to pay these debts. Floating rate works for investors, but there's a limit to how far you can push it. And I don't think anyone really knows yet where that limit is.”
-Grant Murgatroyd, Head of News at Preqin, contributed to this article.