How long can the ‘golden age’ of private credit last?

Private credit managers have gathered hundreds of billions to fund credit-hungry companies in a time of economic headwinds. But some investors worry that the perfect conditions fueling the asset class won’t last forever.

Yields in this space have been generous, but some people don’t expect base rates to remain at 5.5% for the life of a private credit fund or individual loan. “When direct lenders say they can deliver a 15%, now 12%, return, that is very shortsighted,” said one private credit investor.

Surely, private credit has compelling selling points: High interest rates and a shortage of credit have allowed lenders to extract higher returns. These players have benefited from increases in base rates, spreads and closing fees over the last two years.

In fact, the total capital raised for private credit strategies, which include direct lending and other subsegments, hit $94.9 billion in the first six months of 2023, surpassing the $91.4 billion raised during the same period in 2022, according to PitchBook’s H1 2023 Global Private Debt Report.

While the buzz around private credit seems boundless, its performance hasn’t been tested over a real economic downturn. And some allocators are watching with caution.

“This is the golden age of reporting and awareness, but time will tell if it is from a deployment and returns perspective,” said Matthew Stoeckle, a director on the capital solutions team at Liberty Mutual Investments.

A healthy dose of concern

Some allocators, worried by weakening fundamental outlooks and a lack of stringent covenant protections, have lurking concerns about whether private credit lenders can actually deliver the outstanding returns they have promised.

There is an expectation that earnings pressure will start among smaller-cap companies and spread to the direct lending market, which extends loans predominantly to mid-sized businesses, said one limited partner who allocates to private credit. Deterioration in earnings may impede a borrower’s ability to service its debt.

Median EBITDA growth of nonfinancial companies in the Russell 2000 Index slid to 5.7% in the trailing 12-month period ended in Q3, continuing the downward trend since Q3 2021, according to PitchBook’s latest Quantitative Perspectives report.

Win large deals, terms are covenant-lite

Meanwhile, laxer terms and weaker structural protection in select private loans add another source of unease for investors in private credit funds.

While private credit loans are considered to have a sufficient equity cushion to absorb asset stress should defaults occur, certain deals came with loose structural protections as lenders gave up investor safeguards to win deals in a competitive market.

In October, an analysis by Moody’s found evidence of large private credit loans increasingly lacking provisions that offer lenders greater protection.

The rating agency showed that only 7% of private credit deals larger than $500 million had maintenance covenants—provisions that enable lenders to make regular checks on a borrower’s financial health. The bulk of deals worth less than $250 million did offer these provisions.

Moody’s said in its report that terms are expected to converge between private credit loans and broadly syndicated loans, which tend to have fewer covenant protections.

Tighter spreads

Meanwhile, other issues may hamper the performance of private credit.

If more capital flows into the market, the increased competition will compress spreads, stripping out the high returns that lenders can currently extract on private credit loans.

Spreads on new issues have declined by 25 basis points to 75 basis points compared with 12 months ago, as more lenders have sped up their pace of investment to catch up with their target deployment schedules.

And there are more potential risks to watch: Among them are borrowers’ ability to afford more expensive debt, lenders’ ability to work out underperforming loans and the question of whether managers can continue to deploy the capital they raised when M&A deal flow is slow.

All told, yields on private credit loans remain high. Those issued in the direct lending market today yield between 11% to 13%, compared to 7% to 10% on deals issued in 2021.

“This vintage of private credit deals that are closed in 2023—and I would hypothesize, through 2024—are believed to be the highest returning vintage of private credit we’ve seen in a decade,” said Chris Lund, co-portfolio manager at mid-market lender Monroe Capital overseeing its direct lending strategy.

While this is a favorable moment for private credit, its resilience hasn’t been tested during a real downturn.

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