It looks like this could be a landmark year for the world of private debt.
Last week, Ares Management announced it had secured $34 billion for its US senior direct lending strategy. It may not be a record-breaking fund (more about this later), but it is the latest in a spate of outsized private credit fund closes.
In June, HPS Investment Partners closed another giant, securing $21.1 billion for its flagship Specialty Loan Fund VI. And in May, Bloomberg reported that Goldman Sachs, Citigroup and Wells Fargo have plans to amass more than $50 billion to capitalize on the strategy.
Overall, private debt AUM has risen to more than $1.6 trillion, according to PitchBook’s 2023 Global Private Debt Report, with dry powder of over $500 billion.
Much of this private debt capital now underpins the private equity industry. Not just through deal financing, but at every layer of the PE machine, whether at the fund level or portfolio level. With debt so intertwined with the asset class, it raises the question of whether there is such a thing as being over-leveraged—particularly during periods of volatility.
In the years since the global financial crisis, private credit funds have expanded their share of the debt market, replacing banks that had pulled back from lending as rules such as Basel III imposed stricter capital requirements.
Fueled by a decade of low interest rates, the private debt market has increased in size as well as complexity.
Now, deal financing is just part of the picture. Debt instruments are now applied throughout the PE business model, including subscription lines, which are short-term financing secured by the uncalled capital commitments of their LPs. Net asset value financing, or debt secured against the value of the portfolio, has also risen in popularity and can be used to finance add-ons, refinancings or even LPs distributions. In the case of the latter, PE firm 17Capital has projected that NAV financing could increase from $100 billion to $700 billion by 2030.
More types of leverage are emerging. For example, there is the ManCo loan, where financing is secured against management fees and proceeds can be used for anything from new strategies to funding a GP’s equity stake in a PE fund.
Debt is not an inherently bad thing. Beyond potentially enhancing returns for investors, debt tools offer GPs the flexibility needed to optimize their operations and strategically manage their portfolios.
As demand for debt has grown, more players emerge. The banks, which previously retrenched from the market, remain active by investing in private debt funds or launching their own strategies. For example, the $34 billion Ares Management fund only raised $15.3 billion in actual commitments—the rest came from separately managed accounts and “anticipated leverage.” Billions of dollars of bank loans will boost Ares’ ability to lend. But for the banks, financing Ares is a lot less risky than giving out loans to middle-market companies.
Although with the era of cheap money over, the increasing amount of leverage is also raising concerns.
With the sheer levels of debt taken out not only by PE firms, but also in the wider financial markets, it is difficult to ascertain just how much there actually is. The lack of transparency among private credit funds, which don’t have the levels of disclosure requirements as to performance, loans and investors, increases the level of risk in the market.
The key problem is just how interconnected all the players are in the market. Private credit funds are loaning to PE firms and their portfolio companies while also taking on leverage from banks.
The latter, in turn, is also providing financing to the PE firms. Tools like NAV financing are spreading the risk from one single company to an entire portfolio. Private debt funds will also have LPs who may have committed to a PE strategy, too.
One player is lending to another and another, and much of it is being done away from the gaze of regulators. Different credit standards are being intertwined, and too many investors and lenders muddy the waters as to who in the end will be left holding the bag if the music stops.
Finding vulnerabilities
Regulators and institutions have begun to express concern over the levels of debt in private equity. An IMF report stated that while leverage deployed by private credit funds is typically limited, they may still face significant capital calls in a downside scenario due to the network of other parties that are leveraged.
The Bank of England echoed similar concerns while noting in its Financial Stability Report in July that global default rates on leveraged loans have more than tripled—rising from roughly 2% in early 2022 to around 7%.
The likelihood of the debt system crashing down is low, even according to the IMF, but there are vulnerabilities in the relationship between private equity and debt that should not be overlooked.
As to the question of how much is too much? As these things tend to go, we probably won’t know until we’ve passed it.
Featured image by Jenna O’Malley/Pitchbook News
