Private credit is experiencing what can be described as a “Goldilocks moment” in the financial industry. Compared to other investment areas, it is widely accepted that the asset class has reasons to be appreciative of the current conditions. However, labelling the current period a “golden age” without considering possible downturns might be deemed premature. How can the industry ride this wave of opportunity?
Over the past decade, this sector has witnessed remarkable growth, and the present moment offers a distinctive set of circumstances that favour its expansion. Private credit, currently estimated at $1.6 trillion, is about 12% of the global alternatives market, and is expected to nearly double by 2028 to reach $2.8 trillion ; direct lending, infrastructure debt and special situations being the most popular investment strategies.
Private credit is experiencing what can be described as a “Goldilocks moment” in the financial industry.
Private credit certainties offer an edge over other asset classes. Indeed, the floating-rate nature of the loans, the premium to public debt market, strong covenants and robust corporate fundamentals are key components contributing to the asset class reputation.
What are the main tailwinds and headwinds?
While the asset class fundamentals are particularly appealing in the current interest rates environment, recent trends and factors have contributed to this sweet spot: the growing demand for bespoke and flexible financing is leading private credit to gain market shares against its more liquid alternatives (broadly syndicated loans), the investor base is enlarging to wealth management channels (generating long-term democratisation expectations), and finally innovation through digital transformation.
It is worth noting that there are regional disparities. The US market remains the most mature and largest one (in terms of number of opportunities). Europe has evolved and grown very quickly in the last 10 years in a context of soaring direct investments, with still very high growth expected driven by an increasing penetration of private credit solutions adopted (as opposed to bank financing). Asia Pacific is a smaller but dynamic market, with potential for very attractive risk-adjusted returns.
While the private credit market is burgeoning, it is not without its challenges.
Economic downturns could impact credit quality and default rates. While interest rates are well received because of the variable rate nature of these loans, no one should underestimate the rising pressures on borrowers to service their debt.
Increasing competition among market players is also becoming a potential roadblock. As private credit gains in traction, the rivalry amid lenders is increasing, leading to a narrowing of lending spreads which could in turn impact profitability.
Complexification of fund structuration with parallel vehicles, segregated mandates, monitoring of FX impacts are also some challenges to be addressed. Investments into technology with full end-to-end operating model is key into this context for accuracy and scalability of the processes.
Different fund jurisdictions have varying regulations and maintaining compliance can be complex: there is an overall trend towards more scrutiny. As an example, the SEC new private fund adviser rules, adopted in August 2023, are intending to protect private fund investors by increasing transparency, competition, and efficiency in the private funds market. The new requirements will have structural impacts on disclosures, reporting, expenses and operations.
Different fund jurisdictions have varying regulations and maintaining compliance can be complex: there is an overall trend towards more scrutiny.
Lastly, constrained capital deployment is a challenge, as Asset Managers are being more and more disciplined in making deals. The largest private credit lenders increasingly compete with the bank loan market, but are willing to maintain strong covenants, speed of deal execution, and the bespoke and flexible nature of the asset class.
Despite these headwinds, continued allocation from Institutional Investors and wealth channels are expected to fuel growth. This will reinforce some of the structural challenges faced by Asset Managers and Investors; including the lack of scalable and integrated services, as well as the widespread skillset necessary to cope with market trends.
How can Luxembourg embrace the opportunity and foster the right ecosystem in this context?
Promoting networking among all stakeholders and combining deep expertise and long-standing relationships between specialised actors is paramount to succeed in seizing this opening.
Attracting and retaining a diverse and skilled talent pool is of greatest importance. This collective expertise is obtained by regrouping experienced professionals from private capital specialists and is also blossoming from industry-academia collaboration.
Partnerships between established players and fintechs are also crucial to provide best-of-breed digitalised services for private credit funds, such as data visualisations, workflows, intuitive document libraries, ESG scoring or advanced analytics. These innovative integrated models are determining to support a high-growth ecosystem.
The private credit market is experiencing a “Goldilocks moment” due to the alignment of several favourable factors.
The continued demand for flexible financing, institutional and retail investors interest and technological transformations are creating a thriving environment.
As the market evolves in the years ahead, regrouping the right expertise and technology in global and integrated platforms will be essential to harness the potential of private credit.
(1) Source: Preqin