Surging growth in private credit funds could contribute to heightened risks for asset managers
Against a backdrop of low interest rates and increased market volatility, the case for exposure to the private debt markets has only gotten stronger. But according to a recent blog post from Vic Leverett, managing director at Russell Investments, those chasing opportunities must also be mindful of certain risks.
“With senior secured loans in private debt offering returns in the range of 5–10%—a significant premium over similar credit risk in liquid markets—investors will continue to seek opportunities to place capital with private lenders,” Leverett said.
A plethora of high-quality companies need to borrow money for growth, he noted, but are unable to get it from traditional lending institutions. Similarly, many companies with otherwise sound businesses may be going through temporary challenges, but have solid prospects of getting through with strong balance sheets.
“Some of the most attractive opportunities we are seeing currently are senior–secured corporate debt, real estate debt, opportunistic corporate, and asset–backed debt,” Leverett said, highlighting their attractiveness from both a return perspective and in terms of the downside protection they offer.
As inviting as the ocean of private debt might be, however, he warned that there are also undercurrents of peril.
Private debt managers are by no means blind to the opportunity. Citing data from the Financial Times and Preqin, he said that both the number of private debt funds raised and the amount managers aimed to raise rose sharply in 2020. The Times reported that from the beginning of last year until October, the number of private credit funds available to investors swelled from 436 to 520; over that period, average fund sizes also grew from a combined fundraising target of US$192 billion to US$292 billion.
“The fundraising target would add to the significant pot of dry powder, worth approximately US$300 billion, that managers already have to deploy,” Leverett said.
Pointing to data from Preqin, he said that dry powder has been on the rise across both private equity and private debt markets. From 2010 up to 2019, dry powder in private debt has risen from around US$20 billion to just north of $100 billion. Because of significant investor demand, lending standards could deteriorate, leading to heightened risks and defaults.
Corporate credit could be the canary in the coal mine. Following a high in 2009 immediately after the global financial crisis, credit defaults remained around historic lows for roughly 10 years. But data from Moody’s Investors Services from January 2018 until January 2021 showed that default rates in speculative-grade corporates rose in 2020, with those in the U.S. nearing 9% in July last year.
“Several factors influence default rates of borrowers, including the amount of leverage, debt coverage ratios, profitability, growth prospects and size, among others,” Leverett said. “Managers must balance all these factors to minimize defaults and maximize the recovery in case of default.”