Market Views: Is a bubble brewing in private credit?
Private credit has evolved from a niche investment to a multitrillion-dollar market, attracting a diverse range of investors. Rising interest rates have heightened the appeal of the asset class as an investment strategy.
This extraordinary growth in both scale and diversity has prompted questions about potential risks and whether the market may be entering bubble territory.
A primary concern in this evolving landscape is the changing behavior of traditional banks. As these institutions become increasingly selective in their lending practices, they may be inadvertently channeling riskier or less attractive financing opportunities towards private credit providers.
This shift could potentially concentrate higher-risk assets within the private credit sector, raising questions about the overall stability of the market.
At their core, financial bubbles involve a willingness of investors to finance assets at values that, in hindsight, were well beyond their fundamental value.
Credit often plays a key role in the formation of such bubbles, as increased lending facilitates more frequent asset turnover and can ultimately lead to a rapid and unsustainable surge in valuations.
The private credit market's current trajectory has some observers drawing parallels to historical bubble patterns, though opinions remain divided on whether the comparison is justified.
AsianInvestor asked fund managers how likely a bubble scenario actually is within private credit markets.
The following responses have been edited for brevity and clarity.
Martin Barnewell, investment director of private credit
abrdn
We have seen significant growth in private credit as an asset class due to a number of positive factors such as its diversification benefits, bespoke nature and potential to deliver enhanced yield.
Private credit is a broad and diverse universe of investment strategies which covers an array of distinct asset classes with their own risk and return profiles ranging from investment grade senior secured lending to higher yielding, distressed and subordinated strategies.
Direct lending markets have especially grown at a rapid rate. We expect an increase in defaults in this area due to the prevailing economic environment and the weaker nature of the borrower base.
Our focus is typically on senior secured investment grade private credit which is well positioned due to its defensive and more conversative structures where we lend to high quality counterparties.
We are very positive on the fundamentals for commercial real estate debt due to the recent correction in capital values which makes an attractive entry point and fund financing where we focus on shorter dated high quality investment grade subscription financing.
While we expect some areas of private credit to experience market stress in the coming years, other sectors present attractive investment opportunities and we are seeing growing interest from investors globally and in particular from Asia.
Rich Byrne, president
Benefit Street Partners, a wholly owned subsidiary of Franklin Templeton
Private credit is here to stay. During some of the more turbulent times in the past few years when rates first started going up, we saw companies that would've otherwise been financed in the broadly syndicated loan market migrate over to the direct lending market.
The markets are very efficient – they are always in search of liquidity and there is an ever-growing amount of capital pursuing the opportunity. Pension funds, sovereign wealth funds and retail investors are all in search of better risk-adjusted returns.
This demand brings capital flowing into lenders, and lenders are in search of deals. The problem is that mergers and acquisitions (M&A) activity has been light.
I view it as very short term because valuations changed when interest rates went up. Financial sponsors want to sell businesses to raise the next round of capital, but they can't do that without monetizing their investments. Yet they also don't want to take monetisation without attractive returns.
So, they're waiting for rates to come down. Meanwhile, the buyers only want to buy if they're cheap, so we're in a stasis period. Regardless, the flow of capital into private credit continues to increase.
Michael Jones, managing director
PGIM Private Capital
An increasing number of managers and growth in the size of the funds for well-established managers have resulted in spreads and terms being bid down as managers have needed to deploy capital in an environment where M&A activity has remained subdued.
Many managers have not yet been cycle-tested as most have been established following the GFC. This could create opportunities for well-established managers as the newer funds will need to spend more time, and resources, on managing their portfolios or dealing with challenged situations involving businesses with capital structures that were established during the low rate environment.
However, private credit should remain an attractive asset class for investors as it primarily involves a senior secured first lien security. This means investors are sitting at an attractive position in the capital structure as the starting position is often with a loan to value through the senior debt of less than 50%.
Downside risks for investors should be manageable – as long as lenders have been disciplined in their structuring to ensure that they have the terms and other protections in place to allow them to get back to the table and negotiate enhanced economics or protections - or require additional support from shareholders – if the business is underperforming while also minimising the risk of asset stripping.
Matthew Darrah, head of underwriting, direct lending
Principal Asset Management
We don’t believe there is a bubble emerging in private credit markets.
The fundamental drivers of the supply/demand imbalance that has led to the ascendance of private credit continues with banks retreating from lending to middle-market businesses and private equity continues to have significant dry powder available to buy companies. Private equity dry powder is around 5x private credit dry powder despite the private credit market’s growth.
That said, we do believe the supply/demand imbalance is greater in the lower – defined as sub $15 million of EBITDA – and core – $15 million to $50 million – middle market, as 56% of the capital raised in direct lending since 2019 has gone to the top 25 managers.
These flows have forced managers to move up market where they increasingly compete with the broadly syndicated loan and high yield markets. Transactions in the upper middle market are often completed at higher than historical leverage levels, on a covenant light basis, and increasingly with pay-in-kind toggles.
While we don’t think there is a bubble in the upper middle market, the return characteristics of that market will face headwinds relative to the historical returns of the direct lending market that were driven by lower leverage levels, tight covenants, and cash pay coupons.
Andrew Hendry, Asia CEO
Janus Henderson Investors
We believe private credit will continue to play crucial roles in client portfolios for at least the medium term.
Worries over the fallout from any forthcoming bubbles, though understandable, should be tempered by the fact that market structure has changed significantly since the GFC, as banks’ ability to take on significant risk on their balance sheet have been curtailed. The impact from this change is enduring and should cement private credit as a more important asset class in investors’ portfolios going forward.
This doesn’t mean private credit investors should expect a completely smooth journey ahead with no losses or defaults ahead. Quality remains key for both the asset class and the managers tasked with identifying areas of opportunities in the space.
Additionally, the private credit space in mature markets like the US has become increasingly saturated, leading to weakened covenants and eating into returns. Meanwhile, emerging markets remain underpenetrated for private capital solutions.
Banks withdrawing from lending and leaving behind riskier opportunities is a valid point, but that it precisely why experience and deep sector knowledge and market understanding will continue to be crucial in this space.
Private credit growth has also contributed to change the way that companies finance themselves. The high yield corporate bond universe has been shrinking in size and improving in quality, mostly driven by the number of “rising stars” being upgraded to investment grade, but also as lower-rated firms turn more to private credit markets rather than high yield corporate bond markets to finance their development.
Joe Taylor, managing director, private credit
PineBridge Investments
The answer really depends upon market segment as there are many sub strategies within private credit.
In general, capital providers that maintain strong credit agreement protections, partner with like-minded private equity sponsors, and stick to underwriting disciplines including limiting the number of lending partners for optimal decision-making, should avoid bubble scenarios and sub optimal returns.
Experience and depth of relationships will of course continue to be relevant differentiators.