Private credit’s current participation in PE deals
As a result of global economic meltdown of 2007-2008, the US Senate passed the Dodd-Frank Act of 2010, targeting banks and mortgage lenders among other financial institutions for stringent regulations. From the lender’s perspective, leveraged lending guidelines in the wake of this turmoil led banks to reduce their exposures to risky credit, which provided opportunities for non-bank financial institutions to expand their footprints in the credit market. As private credit market matured over time, private equity (PE) firms started to rely more and more on private credit funds to finance their deals rather than traditional bank financing, mainly driven by the tightening of regulations on Banks and quick and customized offerings from the private credit funds.
Global law firm Dechert in its 2021 private equity outlook reported that 45% of surveyed PE firms have increased their use of private credit financing in buyouts over the last three years. Furthermore, companies along with their PE partners have more flexibility negotiating private credit, allowing the target to have high leverage levels and less stringent covenants. Since direct lending does not rely on loan syndication, faster deal execution is also possible1.
Growth of direct lending is supported by several tailwinds including the withdrawal of banks, the traditional financiers of middle-market companies. Additionally, regulatory requirements for traditional banks are stronger than those for direct lenders, allowing the latter to capture the sub-investment grade credit market with much more ease. Nonbank lenders now account for nearly 89% of sponsored middle-market financings, up from 42% in 2013 (Exhibit 1)2.
Source: Refinitiv (deals submitted to private database)
The selling points of private lenders have become stronger in comparison to traditional lenders like banks. Companies, especially those that have PE partnerships, are increasingly manifesting an inclination for swiftness, surety, suitability, and secrecy offered by private credit, despite its higher cost compared to the syndicated alternative. The share capture of direct loans over syndicated loans has increased over the past few years, hitting an all-time high of 77% in 4Q 20212.
Over the last decade many institutional investors in search of higher yield directed their investments towards private credit because of continued low interest rates offered by the government and other IG corporate bonds. Lastly, sponsor-backed leveraged buyout transactions generate much of the demand for direct loans, and annual buyout deal volumes are now nearly three times higher than they were ten years ago2.
Private credit is already leading financing in middle-market deals
The global financial crisis of 2007-2008 forced banks to limit their exposure to risky credit with a leverage limit of 6x for broadly syndicated loans, though leverage may be higher in private deals, causing the number of broadly syndicated loans in the middle-market space to fall sharply. As PE sponsors still rely on debt financing to complete transactions, sponsors and companies are increasingly turning to private debt markets instead of broadly syndicated markets3.
As the private debt market developed, institutional investors were attracted by the prospect of higher yields relative to other fixed income assets, higher allocations, quicker execution, and expectations for consistent risk-adjusted returns. This increased supply lured borrowers and attracted more PE sponsors, who were looking for another option to syndicated loans to fund small- to mid-market deals3.
According to financial data provider Preqin, AUM of funds primarily involved in direct lending surged to $412 billion at the end of 2020 — including nearly $150 billion in “dry powder” available to finance additional assets (Exhibit 2)3.
Source: S&P Global Ratings Research. Preqin.
Increasingly, PE firms looking to finance big leveraged buyouts are looking less towards traditional lenders like banks and showing more interest towards private debt funds for their financing needs. Examples of larger deals coming through the market from private credit include the $2.6 billion stamps.com transaction or the $2.3 billion loan for the buyout of Calypso Technology Inc. Hence, it will not be surprising to see more top tier sponsor transactions for top credits clubbing together several private lenders to provide large financings4.
Increasing significance of private credit in the PE world
Global private debt fundraising increased by ~4.4x to $192 billion in 2021 from $44 billion in 2010, reflecting the increased interest of institutional investors. Middle-market companies, particularly those owned by PE sponsors, are the most common borrowers of direct lending, accounting for nearly 60% of overall private debt fundraising in 2021, exceeding $100 billion (Exhibit 3). Additionally, more than $500 billion of existing debt at middle-market companies will mature between now and 2026 and will need to be refinanced, further increasing the significance of private debt financing2.
Preqin forecasts that private debt will continue to grow, with AUM reaching $2.7 trillion by 2026 from $1.2 trillion in 2021, overtaking real estate, second in AUM only to PE/VC by the close of 20235.
The past decade of low interest rate has worked in the favor of private markets and specifically PE firms, as investors were on the lookout for higher returns not provided by public fixed income securities. We entered 2022 with concerns around Covid-19, the environment, and inflation – which was further heightened by the Russia/Ukraine war. Global inflation concerns pushed central banks of major economies to hike interest rates as also evident by the most recent 75 basis point increase in the benchmark interest rate by the US Fed, raising the alarm of a potential recession somewhere by the middle or end of 2023. However, according to many experts we could find ourselves to be in the stagflation scenario as well if the war continues to push energy and food prices higher, which is beyond the control of any one central bank.
Future hikes in interest rates, as already indicated by the Fed, will have a profound impact on the economy and major asset classes, including PE firms, as they will increase the attractiveness of public fixed income securities and make it difficult for businesses (many of which are portfolio companies of PE firms) to maintain healthy margins. Furthermore, higher interest rates mean lower internal rates of return for PE firms, as this increases the cost of borrowing for leveraged buyouts and at the same time makes debt repayments more expensive. Additionally, a higher interest rate environment is not ideal if PE firms have planned exits, as this usually decreases the valuation and causes a lower IPO appetite in the market. However, given the huge amount of dry powder available with PE firms, a high interest rate environment can be a good time to hunt for undervalued assets, and more deals could be safely expected during the second half of 2022.
On the other side, private credit reacts differently to market volatility and higher interest rates, as these are less volatile than the public markets, and most importantly the floating rate nature of private credit is an advantage when interest rates are increasing. However, if interest rates are increased to the point that recession is inevitable, this could hurt private credit funds, as it will impact the end customers to whom they have loaned money.
It looks certain from the PE industry trend that over the coming years private debt will be the preferred option of financing for PE deals, despite higher interest rate environments. However, it remains to be seen how much these private debt funds will penetrate the “jumbo financing” deal market.
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2McKinsey Global Private Markets Review 2022
52022 Preqin Global Private Debt Report
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