Private debt continues growing amid gathering headwinds
While its breakneck pace of expansion has created vulnerabilities and intensified competitive pressure, investors remain optimistic about the asset class.
Private debt was one of the fastest growing asset classes during the protracted era of low interest rates in the wake of the 2008 global financial crisis, surging ten-fold between 2007 and 2023. In the US, it now stands alongside high-yield bonds and leveraged loans as a major category of commercial borrowing (see Figure 1).
An array of strategies
The term private debt is often used interchangeably with private credit, but it encompasses a much broader set of strategies, including:
- Private credit, also referred to as direct lending, consists of loans provided by non-bank lenders to companies to finance acquisitions, growth, or to refinance existing debt. The terms are generally negotiated directly between borrower and lender, resulting in tailored solutions and greater flexibility than in public markets. It is the largest category within private debt, having grown from 9% of total assets under management (AUM) to 36% in the 15 years since 2008.
- Mezzanine loans occupy a hybrid position between debt and equity in a company’s capital structure. These loans are typically unsecured and subordinate to senior debt but rank above common equity. In exchange for taking on higher risk, mezzanine lenders receive attractive interest rates and may also obtain warrants or equity kickers, benefiting from the company’s potential upside.
- Venture debt is a form of financing provided to early-stage, high-growth companies that are typically backed by venture capital. Unlike traditional bank loans, venture debt caters to startups with limited assets and cash flows, providing a less dilutive way for them to access capital than selling equity. It can be a useful way to extend the runway between equity rounds, and to avoid the dreaded “down round” – raising equity at a lower valuation than in the previous round.
- Distressed debt investing involves purchasing the debt of companies experiencing financial distress, default, or bankruptcy. Investors in distressed debt seek to profit by acquiring these obligations at significant discounts, betting on the company’s recovery, restructuring, or liquidation value. Compared to direct lending, it also involves assuming high risk in pursuit of high returns (see Figure 2). Another related category is special situations, whereby debt is made to distressed companies with a view to gaining control of them.
- Specialty loans, such as equipment leasing, consumer finance, commercial real estate finance or asset-based finance.
- Infrastructure debt, used for both greenfield development and investment in existing assets. This generally has much longer term than many other forms of debt because of the productive lifespan of the assets.
- Real estate debt, used to acquire real estate as well as securitized real estate loans in the secondary market.
Among these strategies, direct lending has been responsible for most of the growth in private debt since 2007 (see Figure 3). Several factors have contributed to its rise, particularly the stricter capital requirements imposed on traditional lenders in response to the financial crisis, limiting their ability to lend to middle-market firms.
This set the stage for the rapid growth of non-bank lenders, who, in addition to having a higher appetite for risk, can offer quicker approval of funding with less stringent requirements.
Tempering the enthusiasm
Although higher interest rates since 2022 have put pressure on all private market asset classes, private debt has been relatively resilient, with wealthy investors eager to access private credit in particular because of its attractive yields.
But there are growing calls to temper that excitement, with the boom in private credit having attracted a flood of new entrants. The intensified competition to deploy capital has not only put pressure on yields and returns, but has also given rise to concerns of a looming uptick in defaults.
Private debt faces other important headwinds. Because it is predominantly structured as floating-rate debt, further reductions in interest rates could take a toll on providers’ absolute returns.
At the same time, financial regulators are paying closer attention to its impact on overall financial stability and may introduce new rules on the market. They are also considering relaxing capital rules on banks, which could pave the way for traditional lenders to resume serving riskier borrowers. Moreover, there are already signs that banks have become more willing to take on risk on the back of stabilizing economic growth.
Despite these challenges, investor interest in private debt remains strong. The asset class is going through an evolution, with managers looking for continued growth across a broader range of assets and borrowers. That expansion will bring greater complexity, calling for a redoubled focus on due diligence and sound risk management.
It’s worth noting that even while JPMorgan Chase CEO Jamie Dimon has been vocal in calling out the dangers of private credit, his bank has increased its commitment to direct lending. Meanwhile, several major traditional lenders have begun to offer secondary trading of private debt deals, signalling their optimism in its continued growth – and potentially contributing to it by helping to make the market more liquid.
As demand for alternative investment strategies increases, CFA Institute is committed to educating investment professionals on these growing asset classes. Explore our private markets and private equity certificates.
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