Welcome to Financing the Economy 2022, the eighth edition in a series of papers analysing the global private credit industry produced by the Alternative Credit Council (ACC) in partnership with Allen & Overy LLP.
The Financing the Economy research series has charted the story of private credit from niche investment strategy to a trillion-dollar asset class. The 2022 edition confirms that this story remains a global one, with the sector continuing to expand its footprint across Europe and Asia. In both these and more developed markets, the growth of the sector means that SMEs through to large corporates all have access to deeper and more diverse sources of liquidity.
The publication of this research comes at a time when many features of the economy that we have become accustomed to are changing. Previously, dormant factors like rising interest rates and inflationary pressures, alongside regionalisation and re-shoring of supply chains have returned to the fore. These are having a profound effect on the economy, with the impact of their return likely to be felt for several years to come.
In the context of a more challenging outlook for the economy, we have focused this year’s research on the current business environment and real-world impact of the financing provided by our members.
By analysing how private credit managers assess and manage their investment opportunities we hope to provide a valuable window into the role our sector will likely play in supporting businesses of all shapes and sizes through the current uncertainty.
The findings of this research offer reasons for optimism. Lenders have invested in their risk management practices and are demonstrating selectivity and discipline when granting loans. They continue to provide finance as traditional lenders retrench their activity, which validates our view that the sector does not encourage pro-cyclicality and diversifying sources of finance improves economic resilience.
Being a good lender is as much about due diligence and risk management as it is about deployment rates and returns. It is welcome to see that investors in private credit are firmly attuned to this notion and are placing this at the core of their manager selection, due diligence and capital allocation process.
Prudent lending and investment discipline have been at the heart of the sector since its inception, driving its growth and expansion more than any other factor. This paper highlights the centrality of this factor once more as the sector navigates economic headwinds and continues to be a key partner for borrowers and investors looking to do the same.
Deputy CEO, Global Head of Government Affairs, AIMA
Partner, Allen & Overy
Supporting borrowers through uncertainty
Private credit fund managers have continued to expand their lending activity, providing finance to a greater spread of businesses. Private credit funds reported a 20% increase in their lending volumes in 2021 and the sector retains a positive outlook towards deployment opportunities in 2022 and 2023. Firms reported increased deal flow, despite the slowdown in M&A activity, as other liquidity providers retrench. While there has been a notable trend towards loans granted to larger corporates, often in excess of $1bn, our data indicates that businesses in the lower, mid and upper mid-market now have access to deeper pools of private credit capital. The certainty of execution and flexibility of terms offered by private credit fund managers is attractive to borrowers of all types in a challenging market.
Emphasis on prudent lending by lenders and investors
Private credit fund managers have invested in their risk management functions during periods of growth. This is manifesting in tighter lending terms across deal pricing, lower levels of leverage and enhanced covenant protections. There is a greater emphasis on data analytics and risk indicators to assess and monitor the financial health of existing portfolio companies. Where potential challenges are identified or stress occurs, the direct relationship between lenders and their portfolio companies and private equity sponsors incentivises all parties to address these challenges and make adjustments to return the business to a healthy position. Investors are increasingly sophisticated in how they review investment due diligence, documentation and workout capacity across private credit managers. Investors are increasingly using these factors to differentiate between private credit managers and allocate capital.
Choosing the right opportunities in a challenging market
Inflation, rising interest rates and economic volatility are creating multiple challenges for investors and private credit managers. Inflation and macroeconomic risk were identified by 55% of respondents as the biggest challenge for their portfolios and future lending activity. Private credit funds are responding to this by being more selective when deploying capital, focusing on businesses in non-cyclical sectors, those with strong cashflows and the ability to retain pricing power. Floating rate products are proving attractive to investors as a protection against the impact of rising rates. Seniority in the capital structure is seen as important in the current environment, although many lenders and investors are preparing to invest more flexibly across the capital structure in coming years.
Expansion across developed and emerging markets
Our data indicates that private credit managers expect growth to take place across both developed and emerging markets. While the UK and US were cited as the national markets with the greatest growth potential, the aggregate preferences of our respondents reveal that most private credit managers expect Europe and Asia to see significant growth. The research also suggests that this growth will take place across a range of markets in those regions rather than being confined to specific jurisdictions. Much of this growth is being led by the private equity market which continues to spearhead private credit’s expansion into new markets. This development is likely to prove valuable for the European and Asian economies as they seek to diversify the sources of finance available to borrowers.
The investment case for private credit remains compelling
Market volatility and the denominator effect have affected capital raising during 2022 but private credit managers expect this trend to be temporary. Our research finds that investors continue to develop dedicated private credit allocations, with the track record and strength of investor relationships continuing to drive strong capital raising across the industry. While there are differences of opinion about the extent to which private credit will become a mainstay of retail portfolios, UK and EU efforts to support retail investment in private credit through the LTAF and ELTIF are expected to provide new sources of capital for the sector. Industry initiatives supporting harmonisation of ESG risk disclosure through the ESG Integrated Disclosure Project suggests that ESG and stewardship remain a core part of lenders’ activities and this will not diminish despite more challenging markets.
Summary of key findings
Chapter 1 – The investment case for private credit
- Global private credit managers deployed an estimated $127bn during 2021, growing their lending activity approximately 20%
- Private credit managers continue to expand into new markets and strategies
- Though having paused mid-year (2022) due to rapid changes in the macro environment, managers are recalibrating and remain optimistic about deployment opportunities in the next twelve months
- Investment case for private credit is still compelling in rising rate environment as long as macro-stresses remain manageable for borrowers
Chapter 2 – Focus on the borrower
- Borrowers of all shapes and sizes now have access to deeper pools of private credit capital
- Private credit is primarily a source of growth capital for the economy
- Lenders tend to focus on non-cyclical businesses with leadership positions in their sectors
- Flexible credit solutions and certainty of execution continue to be prized by borrowers
- Private equity continues to spearhead private credit’s expansion into new markets
Chapter 3 – Investment due diligence and risk management
- Private credit managers place a premium on due diligence and risk management
- The impact of inflation and macroeconomic risk is the key challenge facing lenders
- Private credit firms will typically invest in fewer than 10% of the total deals they assess
- Firms have invested heavily in their risk management functions during periods of growth
- Firms use a range of indicators to assess and monitor the financial health of their portfolio companies
Chapter 4 – What to expect in 2023
- Track record and strength of investor relationships continues to drive strong capital raising across the industry, despite the impact of the denominator effect
- Retail investor base will continue to grow due to the development of new fund vehicles in the EU and UK
- Industry initiatives supporting harmonisation of ESG risk disclosure to investors
- Investors are increasingly sophisticated in their approach to due diligence and manager selection
The Long-Short Podcast
The Long-Short is a podcast by the Alternative Investment Management Association, focusing on the very latest insights on the alternative investment industry.
Each episode will examine topical areas of interest from across the alternative investment universe with news, views and analysis delivered by AIMA’s global team, as well as a host of industry experts.
In this episode, The Long-Short checks in on private credit markets to mark the launch of the annual ‘Financing the Economy’ paper by AIMA’s Alternative Credit Council and Allen & Overy. To help us unpack the main findings and provide additional colour, we’ve enlisted the help of three guests who were integral to the production of the report. Allen & Overy’s Denise Gibson, Co-Head of leveraged finance, and Hannah Gates, Partner in the leveraged finance team specialising in private credit, join us alongside Michael Small, Partner in credit and markets at KKR.
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