Private debt markets have grown rapidly since the Great Financial Crisis (GFC), with global assets under management (AuM) tripling, from $275bn in 2009 to over $850bn in 2019. The European market accounts for about a third of these assets.
The Covid-19 crisis has had a significant impact across private debt markets, with fundraising and deal making having been affected from early 2020. While the onset of this crisis was unexpected, concerns were already being raised about late-cycle conditions in private debt markets related to underlying economic conditions and to emerging risks associated with demand-supply imbalances, tightening spreads, and looser credit standards which showed up in the prevalence of covenant-lite transactions, increased EBITDA adjustments, and rising leverage. All this led to a challenging year for private debt markets in 2020.
However, prospects are improving for 2021. As the crisis’ peak is probably behind us, this year, the focus will be on new opportunities which should be plentiful based on lower financing from banks that will leave the door open to private debt funds to cover issuers’ financing needs. These needs will include servicing the extra debt that corporates have incurred and the requirement to step up their investment expenditure to adapt to the new challenges brought about by the crisis, such as the need to have short and straightforward supply chains and efficient digital infrastructure.
A key trend on the supply side in 2021 should see markets moving from large underwriting towards a more ‘clubby’ direction, with room for private debt funds to subscribe to those transactions in terms of club deals. This market environment will be investor-friendly, as private debt funds will have more power and leeway to negotiate the legal documentation underpinning each transaction.
On the demand side, there could be opportunities in M&A and consolidation, but stringent selectivity will be paramount on both geographical and sector bases in order to avoid those areas that have been hit hard by the crisis and could experience a spike in defaults.
From an investor standpoint, private debt is an established, systemically and complementary asset class that could be included in strategic allocation analysis, as we also highlight in our recent long-term expected returns publication. Historically, it has delivered diversification, stable income streams, and consistent premium returns over liquid and traditional debt with modest drawdowns over the long term. Additionally, it has been a systemically important contributor to economic growth, thanks to the support it provides to the real economy, as the contribution of banks faded after the GFC due to more stringent regulation.
Private debt encompasses a wide range of opportunities (e.g., senior debt, direct lending, distressed debt, etc) which have different goals, underlying dynamics, and risk-return profiles. In 2021, investors could focus on safer strategies at the top of the capital structure where risk-adjusted returns are attractive, resulting in a key test arising for some limited partners (LPs) and general partners (GPs). Some GPs might even exit the market.