Private debt trends: What’s driving the market now

5 July 2023
The private debt market is surging despite high inflation, rising (but still relatively low) interest rates, and tepid economic growth.

The surge is in some respects unsurprising. Given economic headwinds and continued stock market volatility, investors are seeking alternative investments that provide a measure of certainty. Furthermore, banks are tightening lending standards, creating a vacuum that is being filled in part by private debt.

The numbers behind the private debt market’s rise are remarkable. The market was worth $250 billion at the end of 2010 and has ballooned to $1.4 trillion. Preqin expects private debt assets under management to increase at a compound annual growth rate of 10.8 percent, reaching an all-time high of $2.3 trillion in 2027.

This article looks beyond the numbers into some of the key trends that are driving investors into the private debt market.

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 activity, including venture debt activity, is a natural extension of private equity. 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 also worth noting that private equity firms are particularly relying on mezzanine debt as an asset class.

A continued shift from bank lending

Banks' increasingly stringent lending policies have contributed to the growth of private debt. Banking regulations, such as Basel III, that require higher capital adequacy have made it difficult for banks to make money through lending. They must put aside funds, even in low-interest-rate environments, which can create a vacuum in the market. In recent years, when interest rates were at historic lows, that vacuum was filled in part by private debt.

Many businesses facing financial difficulties are now seeking loans, but banks may not provide the necessary funding. Consequently, companies may have to rely on obtaining private debt instead.

Acceptance of riskier strategies

In the still relatively low interest-rate environment, many investors are accepting more risk to gain returns, including the traditionally high risks associated with private debt. We will likely see a steady flow of distressed debt for some time, which will result in opportunities, provided investors are willing to accept the risk. Data indicates they are.

In the summer 2023 edition of its Global PE Barometer Report, Coller reported that 44 percent of respondents intend to raise their private debt allocation target, up from 37 percent six months prior. Traditional equity and fixed-income markets aren’t delivering the desired returns, so diversification into alternatives will persist, with private debt (specifically mezzanine debt) as a focus point.

Accelerated use of technology

The proliferation of technology in financial services will only increase, especially for loan administrators. 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 investment 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.

Lending to smaller companies

Businesses of all sizes are turning to borrowing private debt in the absence of bank lending. However, smaller companies, especially ones that would normally fall beneath a typical lending threshold — say $9 million EBITDA — are increasingly looking 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. This may create the opportunity for future conversion to private equity.

Additionally, it's worth noting that there has been a rise in peer-to-peer lending, specifically in Asia. In general, the loans available are smaller and there are funds specifically designed for investing in these platforms. This is another example of investor appetite for lending to small businesses.

Growing demand for environmental, social and governance (ESG) integration in private debt

A recent Vistra survey of over 600 corporate and investment professionals showed that nearly three-quarters of respondents (71 percent) think ESG will range from moderately important to extremely important with regard to attracting customers over the next year.

Other research shows a similar emphasis placed on ESG by multinationals and investment firms. A Malk Partners’ ESG survey, for example, revealed that a large portion of general partners have already made ESG part of their investment process. Limited partners (LPs), meanwhile, have been the leading force behind the broad adoption of ESG principles. Ninety-eight percent of those surveyed identified LP demand as one of the main reasons for adopting ESG.

It should be noted that ESG implementation in private markets still differs significantly depending on asset type and company size. This is another reminder that investors need to keep a close eye on all trends in the evolving private debt market to minimise risks and take advantage of opportunities.

This is an updated version of a previously published article.