As we begin to emerge from the Covid-19 pandemic, investors are also looking for a measure of certainty. With low interest rates not expected to rise any time soon, and continued stock market volatility, it comes as no surprise that alternative investment options are at the front of many minds.
It would be rash to label alternatives as a passing phase. One only has to look at investments in global private equity in the last decade to see how significantly that market has grown. And with an estimated $1.9 trillion in dry powder at the end of 2020 , according to Preqin, that looks set to continue.
Private debt has followed a similar upward trajectory. From a market worth of $575 billion at the end of 2016 , it grew to $848 billion by the end of 2020. Perhaps more crucially, private debt is projected to increase 11.4 percent annually, to $1.46 trillion at the end of 2025, again according to Preqin.
Considering the current global financial landscape, we thought these private debt figures merited further examination. After review and consideration, we’ve identified five key trends we believe will drive the private debt market in the coming years.
1. A continued shift from bank lending
The growth in private debt has been driven in part by a tightening of traditional bank financing. Increasingly stringent capital adequacy requirements in the form of regulation such as Basel III mean that banks have struggled to make money from lending. They must put aside funds in our low-interest-rate environment, creating a vacuum in the market that has been filled in part by private debt.
As cash-strapped businesses turn to borrowing on the back of the pandemic, banks are unlikely to extend facilities, which will further drive companies toward private debt.
2. A move to private debt by private equity firms
Preqin defines private debt as “the investment of capital to acquire the debt of private companies (as opposed to acquiring equity).” It includes direct lending, mezzanine, distressed debt, special situations and venture debt funds, with direct lending typically being non-bank lenders extending loans to small and medium-sized businesses.
It’s easy to see how private debt is a natural extension for private equity, and that has been our experience at Vistra. Indeed, we set up a private debt team in Singapore at the beginning of 2020 in response to rising private debt activity (including venture debt activity).
Whereas private equity funds in years past might have had a small amount of debt in a portfolio, some appear to be looking at becoming high-volume debt providers or managing a book of loans. It’s worth noting that this private-debt involvement may at some point lead to conversions to private equity, another trend that may develop.
3. Acceptance of riskier strategies
In the current low-interest-rate environment, many investors are accepting more risk to gain returns, including the traditionally high risks associated with private debt.
As we emerge from the pandemic, we will likely see a steady flow of distressed debt for some time. This will result in opportunities, providing investors are willing to take on the risk.
It seems they are. According to a Private Credit Fund Intelligence report, 57 percent of intermediaries plan to increase their private credit (debt) allocation in the second half of 2021. And private debt is the asset class to which institutions are most likely to increase their allocation in the same period.
Pension funds are a key example of this. Traditional equity and fixed income markets are not able to deliver the required returns, so diversification into alternatives will persist, with private debt as a focus point.
4. Lending to smaller companies
Just as businesses will turn to borrowing in the wake of the pandemic, so a wider market will open up to private debt in the absence of bank lending. Those businesses will come in all sizes. Indeed, companies that would normally fall beneath a typical lending threshold — say £7 million EBITDA — may well be able to access private debt.
A small company that would in the past have been a natural fit for venture capital, for example, may now turn to private debt. As mentioned, this may create the opportunity for future conversion to private equity.
As a side note, we’re also seeing an increase in peer-to-peer lending, particularly in Asia. The loan sizes are typically smaller and some funds are set up to invest in these platforms. This is another example of investor appetite for lending to smaller businesses.
5. Accelerated use of technology
The proliferation of technology in financial services will only increase. In the private debt space, we expect technology to be used not only for investor reporting, but to gain a competitive advantage.
Sophisticated artificial intelligence tools and cutting-edge tech will be able to analyse investment data, help make investments decisions and conduct due diligence. Automation of systems will allow lenders to make these decisions and carry out transactions at speed.
Technology will also be fundamental to peer-to-peer lending platforms, particularly as they grow.
The private debt market will continue to be dynamic, and investors must continue to closely monitor trends to lower risks and maximise opportunities.
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