Stubbornly high borrowing costs and persistent inflationary pressures are exerting strain on cash flow stability and certain asset valuations. Consequently, they are sharpening the medium-term rate and return outlook, likely leading to increased transaction activity across private markets. Additionally, the global economy, bolstered in part by robust growth in the United States, has demonstrated remarkable resilience.
Furthermore, ongoing challenges faced by small and mid-sized banks in adapting to evolving regulations and funding requirements are expanding the investment landscape for private lenders and bolstering return potential. This development is particularly advantageous for seasoned lenders capable of navigating credit risk across economic cycles.
In essence, there are positives to an extended period of higher interest rates. As traditional bank lending diminishes and public markets shrink, the private market universe continues to broaden. Consequently, we anticipate appealing opportunities across the risk-return spectrum. What makes private credit an appealing consideration for investors in a high interest rate environment?
Rapid Growth and Opportunities
The sustained growth of private credit has been significant. Before 2008, private credit effectively did not exist as a distinct asset class. By 2023, total assets weighed in at about $1.6 trillion—roughly the size of the US high-yield bond market. Those assets are expected to reach $2.3 trillion by 2027.
This vast pool presents significant opportunities for investors, particularly in corporate credit. Furthermore, the inclusion of other forms of private credit, such as commercial real estate, infrastructure, and consumer-oriented specialty finance, amplifies the opportunities set even further.
However, it is crucial for investors to choose their positions judiciously. High rates may burden some borrowers and introduce additional risks for lenders.
Effective Form of Active Investing
Navigating a market beset by these cross-currents necessitates an active approach, and private markets offer an effective form of active investing. Lenders can tailor loans to suit prevailing market conditions and specific borrower characteristics. Today, this may involve lending against reset asset values at conservative loan-to-value ratios and negotiating protective covenants.
Private credit transactions are negotiated directly between the lender and the sponsor or borrower, emphasizing extensive due diligence and downside protection. Private lenders aim to secure stronger structural protections, including covenants and higher call premiums. The robust deal flow in private credit reflects borrowers’ pursuit of certainty in terms, flexibility in structuring, and a more efficient process compared to the public market.
Strong Return Potential in Direct Lending
High rates dampened deal activity in direct lending last year, which typically accounts for about half of the global corporate private debt market. However, with average yields surpassing 12% in 2023, the strategy yielded strong returns for investors.
Although spreads on new deals have narrowed in early 2024, the base rate used to price direct corporate loans is anticipated to finish 2024 around 4.5%, well above the sub-1% levels that prevailed for years after the global financial crisis. This will keep new-issue yields in private credit above historical levels, promising high return potential for investors.
In a cycle of rising interest rates, characterized by persistent inflation, fixed-income investors may struggle to achieve satisfactory yields on their long-duration investments. However, in such an environment, floating rate loans, particularly those within private credit, become highly attractive. This is because income from these loans can increase alongside rising interest rates.
While some borrowers may struggle with high rates, a manager’s ability to construct resilient portfolios rooted in strong upfront underwriting, appropriate structuring, and active portfolio management across existing positions will be paramount. Nonetheless, relative stability in rates and narrowing bid-ask spreads should help boost overall deal volume.
Lower Volatility
Private assets derive their value from the fundamentals of underlying companies, shielding them from mark-to-market volatility. Floating rate loans often track three month reference rates, making them among the lowest duration investments available to investors. Additionally, private assets typically exhibit less volatility and lower correlation, given their absence from public market trading.
While “higher for longer” interest rates may present some hurdles, the overall economic outlook appears promising. Yields are expected to remain well above pre-pandemic levels, and the private credit market continues to expand rapidly. In our view, this bodes well for lenders and investors alike. Learn more and explore opportunities by reaching out to us at AshtonBridge Capital.