Private credit booms while deal activity slows

Volatile public markets and interest rate increases could lead more investors to boost their exposure to private credit at a time when the same economic factors are threatening to slow transaction activity in 2022 by credit managers' primary customers — private equity firms.

A drop in private equity transactions equates to fewer lending opportunities for private credit managers.

According to alternative investment consulting firm Cliffwater LLC, 75% of private credit deals are for private equity-backed companies.

Already in 2022, global private credit and private equity transactions are down from 2021 levels, despite nearly $2 trillion in private equity dry powder, data from London-based alternative investment research firm Preqin shows. The question now among managers is whether that trend will continue for the remaining three quarters.

In the first quarter, there were 201 private credit deals worldwide worth a combined $54.8 billion, down from 400 transactions with a combined transaction value of $63.3 billion at the end of the year-earlier quarter, according to Preqin. During the same period, there were 2,012 private equity transaction valued at a combined $185.4 billion at the end of the first quarter, down from 2,265 deals with a total value of $200.5 billion.

At the same time, capital is continuing to pour into the private credit asset class.

In 2021, private credit funds amassed about $190 billion, the largest fundraising year since 2017 when managers raised nearly $202 billion, according to PitchBook Data Inc.

And credit managers are continuing to have success raising new funds in 2022. On April 6, The Carlyle Group Inc. announced it held a final close of its second upper middle-market direct lending fund, Carlyle Credit Opportunities Fund II, at its $4.6 billion hard cap.

For investors, there's a lot to like about private credit. These investments often pay regular income, tend to be less volatile than liquid fixed income and much of the loans are floating rate, which can take advantage of higher interest rates.

A survey of 224 U.S. asset owners conducted in December by trade group Alternative Credit Council and data provider With Intelligence showed that 40% of all investors and 57% of public pension plans intend to increase their commitments to private credit in 2022. The reason cited by the majority of the asset owners, 55%, was to reach their target allocations, followed by 37% citing low fixed-income yields.

Traditional fixed income has been the biggest drag on investors' portfolios, and Cliffwater executives expect more investor capital to move out of fixed income into private equity and private credit, said Stephen Nesbitt, New York-based CEO of Cliffwater LLC, an alternative investment consulting firm.

Investment-grade fixed income reflected by the Bloomberg U.S. Aggregate Bond index was down 5.93% in the first quarter, down 4.15% for the one-year period and up 2.24% in the 10-year period ended March 31. "This low return is a high price to pay for a 'risk-off' asset," Mr. Nesbitt said, referring to fixed income, which has lost that attribute due to inflation.

"We have argued that private debt, particularly direct lending, is a better substitute" because yields are higher and are floating rate, so they go up with interest rates, and volatility is about the same as investment-grade bonds, Mr. Nesbitt said. Credit spreads did widen early in the first quarter between private credit and public markets in some sectors, particularly in syndicated loans, but they narrowed as the quarter progressed, he said. Widening credit spreads can suggest increased risk.

The Cliffwater Direct Lending index return was 12.78% for the calendar year 2021, up from 5.45% in 2020 and 9% in 2019. During the same periods, the S&P/LSTA Leveraged Loan index return, which tracks the leveraged loan market, was 5.2% in 2021, 3.12% in 2020 and 8.65% in 2019.

"The real outside danger" for private credit is that inflation causes the Federal Reserve to drive up interest rates and the economy dips into a recession, Mr. Nesbitt said. "I have no crystal ball but that doesn't look imminent," he said.

In 2021, private credit earned back the declines suffered the year before when returns were hit by the pandemic. This year, private credit should produce the yield investors expect, Mr. Nesbitt said.

Likewise, Mr. Nesbitt doesn't expect a pause in private equity transaction activity for 2022, despite its slow start, due to the amount of dry powder private equity managers have to spend. "There's been a bit of an ebb, but we still have reason to believe that private equity will be on trend in terms of activity," he said. "I don't expect a really good year or a really bad year. Just on trend."

Marc Lipschultz, a New York-based co-founder and co-president of Blue Owl Capital Inc., said during the alternative investment firm's Feb. 17 earnings call that the $2 trillion in private equity dry powder cited by Preqin will be invested with "private lenders clearly picking up substantial share" of the business. However, he acknowledged that "when there's volatility in the markets, it sometimes causes some slight pauses." Blue Owl had $94.5 billion in assets under management, including $39.2 billion in private credit, as of Dec. 31.

Trevor Clark, Chicago-based founder and managing partner of Twin Brook Capital Partners, the middle-market direct lending subsidiary of $51 billion alternative investment firm Angelo, Gordon & Co. LP, said that deal flow was muted in the first quarter as deal-makers waited to "get a line of sight" on macroeconomic events including the war in Ukraine and supply chain issues before investing their money.

Mr. Clark said he doesn't expect transaction activity to sink to the lows of 2020 or rebound back to the high level of transaction activity investors saw in the second half of 2021. Even so, not all managers will benefit from the deal flow. The second half of 2021 was such an active year for private equity-backed mergers and acquisitions that most private credit managers did well.

The investment environment is changing and not all private credit managers will continue to perform well, Mr. Clark said. "We will see more pressure brought to bear" from higher interest rates and supply chain issues, he added.

There will be "a delineation" between the private credit manager winners and losers, Mr. Clark said.

"In periods of broader economic stress, you see a renewed focus from the investor and the borrower side on partnering with groups (private credit managers) that are known and reliable and are a proven commodity," he said.

Current macroeconomic factors such as inflation, interest rate increases, supply chain issues and rising human capital costs do not work in isolation, Mr. Clark said. This environment could cause a pause of some private equity deals "on the margin" and could result in some portfolio companies finding they are unable to pass on rising costs to customers, making it more difficult for these companies to pay the debt service on their loans, he said.

As for public market volatility, there is little correlation between the public fixed income and the private credit markets, Mr. Clark said. Fixed-income market volatility could make private credit, especially direct lending, more attractive to investors, he added.

So far, the private credit market, which tends to lag the liquid markets, has been "relatively stable and open to new issues," said Bill Sacher, New York-based partner and head of private credit at alternative investment fund-of-funds and direct investment manager Adams Street Partners LLC. Borrowers that are having difficulty issuing debt on the public markets due to its volatility are turning to the private markets, Mr. Sacher said.

"Perhaps, in part, due to the increased deal flow, we have also seen some moderate widening of credit spreads," Mr. Sacher said in an email.

Thus far, private equity deal-making hasn't been greatly affected by rising interest rates because they are still relatively low by historic levels, he said. "Eventually, increases in interest rates could have a moderating effect on today's LBO leverage multiples simply because the underlying companies will no longer be able to service that level of debt."

Mr. Sacher added that several factors likely led to fewer transactions in the first quarter. Last year was an unusually busy year because were there was a record amount of private equity dry powder, pent-up demand from buyers that had paused investment during the pandemic-related shutdown, record high company valuations motivating sellers and an expected increase in capital gains tax that caused a rush of company owners to sell their businesses by year-end 2021, Mr. Sacher said. "All of this probably resulted in pulling some 2022 deal flow into 2021 and contributed to a relatively slow first quarter this year."