Private Debt Outlook 2025: Good things come to those who wait

January 6, 2025

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Investors’ search for yield should be good news for direct lending globally in 2025, as our heads of private debt explain.

Private credit has experienced remarkable growth over the past two decades to become a cornerstone of the alternative investment universe. While much of this growth was driven by the search for yield during an extended period of low and even negative interest rates, the asset class continues to offer a compelling and sizeable investment opportunity. 

We continue to favour the lower-middle market, where we see significant opportunities to provide capital to companies with robust credit fundamentals as banks scale back lending. In our view, this segment will continue to offer attractive risk-return dynamics, particularly as competition and margin compression intensify in the upper-middle market.

Illiquidity premia likely to persist

Investors primarily allocate to private debt to access the illiquidity premium; an additional return over and above what is available in public markets to compensate for the lower liquidity in the assets.

As Figure 1 highlights, the asset class has provided a yield premium over leveraged loans and 3-month Treasuries over the past 20 years. This risk-return profile is particularly attractive for long-term investors, who need assets to match their investment horizons rather than liquidity.

Figure 1: Yield comparison for private debt versus leveraged loans and government bonds

Past performance is not indicative of current or future results.

Source: Cliffwater LLC: Are current private debt yield spreads sufficient? as of 18th October 2024. The Cliffwater Direct Lending Index (CDLI) is used as a proxy for Global Private Debt as it provides publicly available data  For illustrative purposes only. Index performance is for illustrative purposes only. You cannot invest directly in the index.

Lower middle market sweet spot

While the global private debt market has seen tremendous growth, the target for many lenders has been companies in the middle and upper-middle markets. Conversely, the lower-middle market faces an immense shortfall in funding, estimated to be around US$5.7 trillion per annum; these companies represent c.90% of companies globally and contribute around 50% of GDP.¹

As most capital has been raised in the larger segments, we see opportunities to secure significantly more attractive risk-adjusted returns in the lower-middle market. Less competition has helped keep spreads relatively stable – a theme we expect to continue in 2025. This contrasts with the spread compression seen in the upper-middle market, which faces stiff competition from the broadly syndicated loans market. According to Bloomberg analysis, spreads on larger private credit loans have tightened by at least 100 basis points since early 2023.²

There is a common perception that the lower-middle market is more risky. However, a recent report by Cliffwater highlighted the US lower-middle market has provided an adequate risk premia to the upper-middle market over a 5-year period.³ We believe that to invest in the lower-middle market requires significant expertise in credit analysis and strong local networks.

Given the size and distribution of companies in the lower-middle market, barriers to entry are relatively high. We think that will continue given the time and resources needed to build up local regional teams with in-depth market and jurisdictional knowledge.

Asset class growth

Against a backdrop of increasing regulatory constraints on bank lending, the growth of the private credit market has been remarkable; in the last 10 years, the market has tripled in size to around US$1.5 trillion.⁴ On a global scale, non-bank financing now represents just over 50% of financial assets,⁵ with private credit the second-largest private markets strategy behind private equity.⁶

Since 2022, higher interest rates have led to a more challenging environment for origination and fundraising. From a borrower perspective, higher rates make it more costly to raise and repay debt; aggregate global deal volume fell from US$1.6 trillion in 2021 to US$1.1 trillion by 2023.⁷ Sponsor-driven M&A activity – historically the main driver of private debt transactions – was particularly impacted.⁸  

During 2024, with rates starting to fall again, there were signs of this trend reversing with fundraising picking up significantly (Figure 2). This is a theme we expect to continue as rates fall, and with seemingly no let-up in demand for private market exposure from institutional investors and, increasingly, the wealth channel.

While firmly established in North America and Europe, private debt in Asia is still a relatively nascent asset class, accounting for 7% of global private credit AUM.⁹ However, it is growing rapidly, having almost doubled in the past five years.¹⁰ It is likely this pattern will continue due to the significant growth potential of emerging and developing Asia economies. At a macro and sector level, there is momentum around industrialization, manufacturing and infrastructure, all of which require significant investment. We think private lenders can be a big part of the solution.

Ongoing need for alternative financing

Meanwhile, from a borrower perspective, demand for alternative sources of capital will continue to increase as rates head back down. We are already seeing signs of recovery in deal flow; a recent private debt deal tracker showed a notable increase in European deal activity from 119 in Q1 2024 to a record high of 252 in Q2 (Figure 3).¹¹

With private equity firms sitting on record levels of dry powder (Figure 4), there is increasing pressure to put that money to work. Falling rates mean lower debt-financing costs - good news for potential buyers. At the same time, lower rates should feed into an improvement in portfolio company cashflows and valuations, which should encourage sellers.

Looking ahead, we will continue to focus on financing build-ups for private equity sponsors whose top priority is not leverage or optimizing their capital structure, but flexibility to grow via acquisitions. Given sponsors’ focus on growth not leverage, this will ultimately lead to lower leverage levels in our portfolios.

If you can’t beat ‘em…..

Final amendments to the Basel III framework will increase the regulatory capital required by banks to absorb unexpected losses on their loan books. If banks must offload non-compliant loan portfolios or execute significant risk transfers with third parties, it could offer a new avenue for direct lenders to source deals outside the traditional channels.¹² 

Additionally, banks are creating partnerships with well-established private lenders; either directly or through syndicate relationships where alternative lenders can bid to buy the debt with the bank retaining a small piece of the loan. In our view, the increasing involvement of banks is net positive for the private credit market, making the lending environment more dynamic.

Transaction size could play an important role with banks more likely to be involved in bigger deals. That could have implications for larger established players in private credit, whose origination is based on direct relationships with big sponsors. It is possible a sponsor could instead go to a bank that can offer to arrange financing through syndicated loans, high yield bonds or private credit.

Big and getting bigger

As we look ahead, we believe the private debt market is poised for continued growth, driven by a persistent illiquidity premium, regulatory constraints on bank lending and borrowers’ need for alternative sources of capital.

While higher interest rates hit deal flow over the past three years, the downward trend in rates could ignite deal activity and consequently investment opportunities, particularly in the lower-middle market. As a result, we believe the asset class will continue to play a vital role in supporting local economies and meeting the risk-return objectives of a wide range of investors.

References

1.International Finance Corporation, World Bank Group, as of June 2024.
2.Bloomberg, ‘Private Credit Is Eyeing Bigger Margins on Loans,’ August 10, 2024
3.Cliffwater, Settling the Upper vs Lower Middle Market Lending Debate, as of 4th December 2024
4,Preqin Investor Outlook H2 2024
5.Financial Stability Board – Non-Bank Financial Intermediation Report, December 2023. Latest available data used.
6.AIMA, as of 18th November 2024. The private credit era, Belle Kaura.
7.Preqin, The Future of Alternatives 2029, October 2024.
8.Baird, ‘Big Deals are Back – 10 Predictions for European PE,’ August 8, 2024
9.Preqin, APAC Q1 Quarterly Update, as of April 2024
10.Preqin, ‘Private Debt Q1 2024’, as of April 2024
11.Deloitte Private Debt Deal Tracker, as of Autumn 2024
12.Macfarlanes, ‘Basel 3.1 – fuel to further accelerate the growth of private credit?’ September 12, 2024

 

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed by Muzinich & Co are as of December 2024 and may change without notice.

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