As we move into 2024 with a 50 basis point rate cut already implemented, private credit faces a mixed yet promising outlook. Private credit is directly impacted by these rate changes. Lower rates reduce returns slightly by driving down the risk-free rate, but they also spur deal flow as more borrowers seek to refinance. This trend could continue with further expected rate cuts in 2025, boosting the volume of private credit deals while slightly tempering returns.
Historical data highlights private credit's resilience during periods of market stress, such as the Global Financial Crisis and the COVID-19 pandemic. Historically from 2000-2024, upper quartile IRRs have outperformed median IRRs by approximately 800 bps, with upper quartile private debt IRRs at 22%, and median IRRs at 14%. This demonstrates the ability of top-performing private credit funds to deliver equity-like returns with significantly lower risk. Additionally, the data shows that private credit tends to perform well in periods of low liquidity, such as after the GFC, as well as in higher interest rate environments, like the recent Fed tightening cycle. Since the Global Financial Crisis, private credit has experienced significant growth in Assets Under Management (AUM), driven by institutional investors seeking higher yields in a historically low-interest-rate landscape.
Investor Trends in Private Credit
Institutional investors, including pension funds and insurance companies, remain key players in the private credit market due to their preference for stable, risk-adjusted returns. As illustrated in the chart below, senior debt has consistently dominated the capital structure of private credit deals since the end of the GFC in 2011, suggesting that GPs and institutional investors prioritize stability by favoring senior positions.
The overall growth in private credit deal flow and institutional demand indicates a robust fundraising environment. Investors continue to allocate capital to private credit funds, and the market’s overall expansion supports this trend. The market has expanded significantly since the GFC, with more private credit funds being launched to meet the growing demand from institutional investors.
Refinancing Stress and Sector Challenges
While interest rate cuts drive deal flow, refinancing stress could pose challenges for certain sectors. Borrowers who secured deals during the low-rate period of 2020-2021 may struggle to refinance in the current environment, leading to an increased risk of defaults. The healthcare sector is particularly vulnerable, as shown by the spike in healthcare private debt defaults from 2019 to 2022. Investors need to be aware of sector-specific risks as they navigate this new landscape.
Private Credit vs. Other Asset Classes
In the current high-rate environment, private credit offers a more attractive risk-adjusted return compared to alternative asset classes like growth or buyout equity. While growth equity and buyouts provide the potential for higher returns, they come with significantly higher volatility and downside risk. Private credit, on the other hand, benefits from its seniority in the capital stack, offering more predictable returns and downside protection, making it a preferred choice for risk-averse institutional investors.
Conclusion
Private credit is well-positioned for growth through 2025. Although interest rate cuts may temper returns, the increased deal flow and continued demand from institutional investors provide a strong foundation for this asset class. With its ability to offer stable, risk-adjusted returns, private credit will remain an essential alternative investment in a shifting economic environment.
