The Private Asset Revolution Is Here
Private assets on the equity and credit sides of capital raising have been growing over the last two decades, fueled by an ability to adapt as the economy, regulatory environment, and markets have evolved.
Institutional investors with long-term investment horizons have recognized the potential advantages of private assets compared to the public markets for decades.
Illiquid private assets may provide the opportunity for enhanced return, yield, and portfolio diversification. The resilience of these assets through major market disruptions has added to the appeal.
Individual investors seeking to expand traditional 60/40 portfolios with alternatives are the next frontier in the growing demand for these assets.
Flexible structures can now provide access to long-term investment strategies while allowing limited liquidity.
The evolution of these two asset classes mirrors our changing economy, and private equity and private debt have played vital roles.
As we navigate a new business cycle with an aggressive Fed and the threat of recession, companies with private equity backing who seek private debt capital may be uniquely positioned to weather the storm.
The Background
Private debt has always been the “little brother” to private equity, but it is catching up quickly. Since 2011, private debt has been the only private asset class to grow fundraising yearly, including through the pandemic.1
Preqin reports assets under management of $1.2 trillion and reports that growth has averaged 13.5% annually since 2010.
With a projected annual growth rate of 17.4% between 2022 and 2026, private credit would be the second largest private asset class, behind private equity, by 2023.
And in terms of all alternative asset classes, private debt is forecast to be the fastest growing over the next four-to-five years.2
What Is Private Debt, Exactly?
Private debt, also called private credit, encompasses several strategies. The largest by far is direct lending to privately-held middle market companies. These companies historically accessed bank funding for capital needs, however, banks have been exiting this market for decades, leaving a void that private lenders have filled.
This was accelerated by regulatory changes after the Global Financial Crisis (GFC). The chart below details the radical shift away from bank participation, from 58% of deals in 2013 to 11% in 2021.
The Characteristics of Private Lending
These loans are direct agreements between the company as the borrower and the private debt lender.
They have several characteristics:
Why Is the Partner So Important?
The original impetus for middle market companies to use private lenders was necessity. As the asset class has matured and lenders have developed relationships and track records, many middle market companies have come to prefer private credit, and also tend to work with the same lender multiple times.
Private lenders can offer more flexible funding, the assurance that a deal will close, and shorter timelines to close. In addition, covenants on the loan work to ensure the lender can provide oversight and assistance if a rough patch arises, as what happened during 2020-2021.
A recent survey by the Alternative Credit Council (ACC) reported that during 2020, private credit manager respondents deployed almost $200 billion in capital, as compared to the $113 billion that had been expected by a similar survey in early 2020. The ACC referred to private credit as a “vital provider of capital support” during economic uncertainty.3
Private lenders’ position as senior stakeholders in the company, and the existence of covenants, often means that private credit managers can act collaboratively with company management, get involved early and mitigate potential issues.
Changes to Private Equity Boost Private Credit Growth
IPOs make headlines but aren’t as common as the media attention makes it appear. In fact, the number of IPOs annually has been shrinking for decades, while the value of the deals and the size of the newly public company have grown.
Looking at the data on IPOs tells an interesting story about how companies that go public have changed. The number of IPO deals plunged 63% from 5,724 in the 1990s to 2,106 in the 2000s. At the same time, the total value of the deals increased from $482 billion to $569 billion.4
The steady-state over the 2000s validates that companies now stay private much longer.5
How are companies remaining private? Growth in private equity assets under management has been nothing short of explosive, with assets accelerating from $500 billion in 2000 to $6.3 trillion by June 2021.6
Private equity investors bring a long-term focus to company growth and are active partners that can provide assistance and expertise across all dimensions of a company’s business model.
Private equity firms are increasingly turning to private credit to fund buyouts. A recent survey found that 45 percent of surveyed private equity firms have increased their use of private credit financing in buyouts over the last three years. This represents a ten percentage point increase over the previous year’s survey.7
The same survey found that over half of surveyed private equity firms prefer private credit over traditional bank financing. The report, based on the responses of 100 private equity managers with $500 million+ in assets under management, attributed this preference to the customizability and dependability of private credit.
Private Assets in Tandem Can Mitigate Risks
The growth of private equity investment in middle market companies has resulted in greater equity cushions. The loan-to-value ratio for leveraged buyouts in recent years has averaged 53-58%.8 This means an implied average equity cushion of 44%.
Institutional private equity owners can also add capital when companies struggle, especially during unexpected downturns, such as the pandemic and the ongoing recovery. The resiliency of private credit with low default rates throughout 2020-2021 is likely partly due to this advantage.
The combination of lenders who can play an active role in helping a company manage debt burdens, along with private equity owners who are willing to contribute additional capital, can result in companies successfully managing a crisis.
From an Investor Perspective
The growth in private credit is also fueled by demand for these assets.
Persistently high inflation is outpacing traditional bond yields, and an aggressive Federal Reserve is committed to bringing inflation down by slowing the economy through interest rate increases. This has resulted in historically negative performance for the traditional 60/40 portfolio in 2022.
Private debt, through floating rate assets, can help mitigate interest rate risk in a rising rate environment.
The asset class offers lower volatility as it is less liquid. Low correlation to traditional credit assets brings portfolio diversification. These attributes make an argument for considering private credit in a traditional allocation that resonates with many investors.
