Demand for private credit set to rise as PE valuations slump

The private debt market has grown at a steady pace over the past decade, and despite a slowdown in deals, investors anticipate strong interest amid higher interest rates and lower private equity (PE) valuations.

Even though the amount of dry powder has skyrocketed from $17.7 billion in 2010 to $147.6 billion in 2020, fundraising has plateaued over the past few years.

Reasons for this slowdown include lower interest rates pre-2022, the pandemic and difficulty in finding deals, industry insiders told AsianInvestor.

PRIVATE DEBT TO GAIN 

However, investor interest in private debt is likely to continue its growth as central banks turn hawkish amid rising inflation, volatile markets drive investors to safer asset classes, and PE valuations fall.

A single-family office investor told AsianInvestor that firms were asking for unrealistic valuations last year.

“You could offer a special purpose acquisition company (Spac) merger valuation at $1 billion, and the target company would say, ‘no thanks, I’ll find someone else that values us at $4 billion’," they said.

Now, the situation has changed, as private equity fundraising globally fell for a second consecutive quarter in Q2 and private equity-backed buyout deals fell across all regions including Asia quarter-on-quarter, according to Preqin data.

“Given where the market now, valuations are obviously coming down. And it's getting harder to be comfortable with the valuations,” Denny Goenawan, managing partner of Indies Capital Partners, a Singapore-headquartered fund house focused on private debt.

“Second is also that exits are becoming harder for private equity and venture capital given that capital markets are slowing down. We see that there's less public issuance in the market, be it on the debt side or on the private equity side.”

He added that investors are now looking for safer and more predictable assets – “that means cash flows, predictability on revenue and so on,” he said. As a result, debt is becoming more appealing than equity to investors.

“In the past you were willing to invest in a company with no cash flow or no visibility of cash flow, because you believe the equity value will keep rising. And this had enough buffer to cover your investment... But I think now they want to invest in safer and more predictable asset classes.”

Asset owners have increasingly looked towards alternatives, particularly private credit, for investments as they faced first low yields on public debt, then the enduring bear market and persistently high inflation.

READ ALSO: Private credit fastest growing alternative asset class among asset owners

Alexis Ng, Asia Pacific managing director at Muzinich & Co, which specialises in debt, agreed that institutional investors have been looking at debt to counter the downsides of PE.

“As markets become a bit more dovish, investors are therefore wanting to look at other alternatives to help them ease off the downsides for having too much in the PE space,” she said.

Investing in private debt meant that lenders would not have to deal with the J-curve associated with PE. “Most of the time, you get interest payments immediately. So I disburse the loan to the borrower, then in three to six months time, the borrower would have started to service the loan by paying the interest payments,” she said.

She added that these privately negotiated debt agreements have characteristics of what investors expect from public debt such as regular coupon interest payments and return on capital, on top of an illiquidity premium.

More conservative asset owners have also been attracted to a type of private lending Muzinich offers called parallel lending.

“With the banking regulations that have come in, it's becoming very expensive for these banks to continue to hold the full loan book on their books. As a result of that, the banks then start to work with private debt managers like us to co-invest in those loans.”

Parallel lending also tends to be more senior than direct lending in the capital structure, which is a draw to investors looking for debt that is as close to an investment-grade (IG) rating as possible.

ASIAN PRIVATE CREDIT

Private credit in Asia also tends to have a shorter timeframe, Ng said. Where European private debt typically has a tenor of five to eight years, the average in Asia sits at around three years.

“With Asia, even though the tenor’s shorter, the interest rates are also higher, because of a combination of factors. One, it's still a growing asset class, and then, there is still this specialisation that's required to be to operate this asset class,” she said.

Private credit has taken off in Asia – for instance, Ares SSG closed its third pan-Asian secured lending fund at a record $1.6 billion last July and Muzinich’s first Asia-Pacific debt fund counted DBS as an anchor investor. DBS said it would anchor up to $200 million or 40% of the total fund size, whichever is lower.

Investors have also expressed concern about sourcing deals in Asia, where each market is vastly different from its neighbour and requires boots on the ground to manage relationships – which is the approach Indies Capital Partners has taken.

“We believe we have the biggest team on the ground for Southeast Asia. And we are more focused obviously, because we only invest in Southeast Asia,” Goenawan said.

The firm started out focusing solely on Indonesia, but has since expanded to the rest of Southeast Asia. “Indonesia is the biggest economy in the region by far, and the one that probably has the biggest mismatch between demand for capital and supply of capital. Indonesia will continue to be the biggest source for deals or funds like us but going forward will take up about 50 to 60% of our portfolio,” he said.

While asset owners might be concerned that an impending recession might mean rising default rates, he said that these economic headwinds meant that people would more likely seek cover on credit, and be more cautious on equities. He added that defaults are already priced in on private credit funds.

Still, the head of asset owner solutions at a global financial institution told AsianInvestor that many asset owners have mandates that prevent them from rebalancing their portfolios too quickly. They added that despite the hype over private credit in the past decade, “the opportunities have not been there.”

“It’s a great asset class… because it has shorter durations, and more protected returns. And as the public markets and credit were getting less and less attractive, private credit was an opportunity. In the US, private credit at some point will surpass probably private equity, but right now, with the current market conditions, that's probably not and what you're going to see.”

“But I think if you look out and we have this conversation in five years, it'll be interesting to see where we're at with that,” they said.