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Once a rising star among investment options, private credit now faces headwinds as defaults increase and traditional banks re-enter the fray as competitors.

Private credit has experienced a meteoric rise, transforming from an overlooked option to a sought-after safe haven for investors wary of the stock market’s volatility. In the first half of 2023, private credit received an inflow of 94.9 billion dollars, matching the previous year’s amount, data from PitchBook reveals. The private credit market surpassed 1,500 billion dollars in assets under management by summer, but is its golden era about to fade?

Helped by relaxed regulations, with Eltif 2.0 but one example, private credit is no longer solely the realm of institutional investors. All significant asset managers and private equity houses have since ventured into the market. In the Netherlands, ING unveiled its plan to offer private market investments, including credit, to clients with invested assets starting from 2.5 million euro. In Luxembourg, law firm Maples has estimated that the market would continue to grow this year after a 45 per cent jump between the summers of 2021 and last year.

Challenges ahead

Looming challenges paint a less rosy picture. Klaas Knot, the president of the Dutch central bank, has highlighted a potential crunch, as 56 per cent of Dutch companies’ debt is up for refinancing in the next two years, a scenario exacerbated by rising interest rates. That puts the corporate financiers - banks and private credit investors - also into focus.

David Miller of Morgan Stanley Investment Management witnessed private credit’s phenomenal growth. He linked its rise to stringent banking regulations post-2008, which created an opportunity for private credit funds to fill the lending void. Private credit’s features, such as variable interest rates and higher yields, coupled with the potential for bespoke structuring, have undoubtedly contributed to its allure. “I’m quite positive,” Miller said.

However, Miller warns of emerging threats. With default rates anticipated to increase, the competition becoming fiercer, and banks returning to underwrite leveraged credit deals, the environment has become more challenging than just a year ago. The slowdown in private equity activities, with 70 per cent of private loans connected to one or more PE entities, is another headwind. The availability of dry powder has not diminished in recent months.

Repositioning strategy

Amid these challenges, Koen Ronda of IBS Capital Allies, which invests some 500 to 600 million in private equity and private credit,  recommends a ‘secondary’ private equity strategy. This move, he believes, is apt during turbulent times. But despite the risks, he remains generally optimistic about the economic landscape and underlines the importance of choosing managers with low default histories.

“For now, it is running pretty well and the economy is still running pretty well. But we are constantly talking to managers and we see that it is not drastically declining for the time being, but it is now becoming a question of who has the best pipeline in terms of deals,” Ronda said.

Miller underscores the significance of the recovery rate alongside the default rate. Funds with senior loans often manage higher recovery rates during defaults than those with mezzanine or junior debt. The proximity of a fund to the financed company also plays a role, suggesting that being closer to the action offers tangible benefits.

Even considering potentially higher default rates, Miller’s optimism persists. If defaults were to rise to 5 percent, with a recovery rate of 50 percent, he estimates a loss of 2.5 percent on a portfolio, resulting in a still favourable net return of 7.5 percent. While this is a decline from prior yields, it outperforms listed bonds. Ronda, however, stresses the importance of a long-term perspective, emphasising that the appeal of private markets endures, irrespective of cyclical fluctuations.

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