Editor's Note: This article is part of our series marking the second anniversary of the pandemic. Other installments include:  After seeing its resilience tested as never before during two years of pandemic-related disruptions, the private debt market is poised for growth as yield-hungry institutional investors extend their hunt for high-performing assets.

Public health emergency lockdowns in 2020 dealt a series of hammer blows to borrowers, pushing default rates higher and creating new debt repayment challenges to both private and public companies. Central bank stimulus programs limited the damage, and helped private debt withstand the effects of the economic downturn.

US private loan default rates peaked at 8.1% in the second quarter of 2020 before falling back to 1.04% in the fourth quarter of last year, according to the Proskauer Private Credit Default Index.

The rise of private debt is being driven by investors' search for higher returns in a prolonged period of low interest rates and recent stock market volatility. Institutional investors are allocating more of their portfolios to the asset class and turning away from more traditional assets to take advantage of the returns offered by private debt. Industry participants said they see no sign that enthusiasm for the asset class will wane this year.

"There is an increasing trend of rotating a small portion of your fixed-income portfolio into direct lending funds," said Jess Larsen, the founder and chief executive at Briarcliffe Credit Partners, a dedicated private credit placement agency, noting that investors were disappointed by the dwindling returns delivered by traditional fixed income.

Last year was a banner year for private debt, with money dedicated to the asset class hitting $191.2 billion, the highest annual sum since 2017, according to PitchBook data.
 
 


In one sign of investor confidence in the continued strength of the strategy, Blackstone amassed $32.6 billion for its new private credit fund last year, which mainly invests in first-lien loans. Also last year, Ares Management raised $8 billion for an oversubscribed direct lending fund, almost double the sum it had first targeted.

Larsen added that some of the largest pension consultants also have advised clients to take capital from other parts of their portfolios—such as private equity and absolute return strategies—and re-allocate them to private debt.

Some large US pension funds have upped their allocation to private debt as they look for ways to increase investment returns.

Two of the largest US pensions—the nearly $482 billion Calpers and $320 billion California State Teachers' Retirement System—both stepped up their private credit allocation last year. As part of a new four-year plan, Calpers set up a 5% private debt allocation target, alongside other moves to increase its exposure to alternative assets, as the pension manager struggles to meet its investment-return target of 6.8%. CalSTRS also added a 5% target allocation to private credit as part of its 13% fixed-income allocation, according to a July report from the pension manager.

Meanwhile, credit managers such as Barings BDC, Golub Capital, PGIM Private Capital and Benefit Street Partners announced a record amount of private debt origination, fueled by the acceleration in M&A deal flow in recent quarters.

In spite of the optimism, private lenders are monitoring threats to the borrowing market, including the potential for rising interest rates and an increase in inflation.

The Federal Reserve has signaled its intention to raise the federal funds rate from near zero starting in March, as inflation has climbed. US consumer prices rose to a four-decade high of 7.5% in January, well above the Fed's target.

While Russia's invasion of Ukraine might affect how quickly the Fed lifts rates, the conflict is unlikely to alter the US central bank's overall policy approach.

As rates rise, the floating rate structure that many private credit instruments use offers investors the promise of more returns, but this also would increase costs for borrowers.

And some credit market specialists said that even a series of rate hikes over the next two years would still leave prevailing rates at relatively modest levels.

"The Fed is signaling at least a 1% rate increase this year, with analysts predicting another 1% hike in 2023," said Randy Schwimmer, the co-head of senior lending at Churchill Asset Management. "That gets us to a 2% or so Fed funds rate by the end of next year, still modest compared to the 5.5% we had in June 2007. We have a long way to go before we're at the level of higher interest rates before the 2008 financial crisis."

Data on interest coverage ratios, which measure a company's ability to pay interest on its debt and is one of the primary measures of risk in private debt markets, also suggests that borrowers on average are in better shape to withstand higher interest payments than in the 2007-2008 financial crisis, said Ian Fowler, the co-head of Barings' Global Private Finance Group.

"Back then, your average interest coverage ratio was around two times, and today just looking at our portfolio, the average interest rate coverage is three times or north of three times, which gives companies more cushion to support higher interest rates," Fowler said.

However, it's important for borrowers to manage their exposure to higher interest rates, he said.

"Historically, it was common in the loan documents that companies have to fix 50% of interest rate exposure," Fowler said. "That has come out of the document in the last five or six years because we have been in a very low interest rate environment. It'd be beneficial for all parties if that language finds its way back in legal documents."

Featured image by NiseriN/Getty Images

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