Private debt management is evolving rapidly, driven by shifting investor preferences, technological advancements and regulatory changes.

There are four trends reshaping its future: mainstreaming of private debt as an asset class; the evolution of business models to enhance competitiveness; the emergence of innovative sub-asset classes within private debt; and, increasing integration of environmental, social and governance (ESG) considerations. 

1. Mainstreaming

Over the past decade, private debt has made a remarkable transition from niche to mainstream asset class, with assets under management (AuM) surging from $400 billion in 2012 to a staggering $1.4 trillion in 2022, according to Preqin, on growing allocation from institutional investors, high net-worth clients and retail.

But today’s high interest rates and worries around potential defaults are leading to questions over the asset class and its ability to firmly establish itself in mainstream finance.

We believe private debt is here to stay for three reasons.

First, the surge in interest rates in 2022 highlighted the stability and resilience of floating-rate assets such as direct lending. While investment-grade and high-yield fixed income markets roiled, direct lending served as a safe haven, making private debt an appealing choice in a higher interest rate environment.

Second, private debt assets offer higher yields and occupy seniority in the borrower’s capital structure. They have a record of superior returns and lower losses compared with other fixed-income segments, underscoring attractive risk-adjusted gains for investors.

Third, private debt has exhibited low to negative correlation with public fixed-income markets, offering investors a good diversification option. As a result, private debt investors can augment their overall risk management and portfolio stability.

Furthermore, regulatory impetus and the eagerness of asset managers to expand offerings is spurring innovation in product development. Consequently, a wider investor base, including high-net-worth individuals and retail investors, are having easier access to private debt.

Given the appealing risk-return profile, expanding investor base and continuous evolution of product offerings, we believe private debt will continue to gain mainstream acceptance, solidifying its position as a prominent choice across investor segments.

2. Seizing strategic shifts for competitive advantage

Private debt managers are adapting strategies and business models to ensure competitive advantage.

One notable trend is the pursuit of permanent capital, which provides a reliable and readily available source of funds for generating fees and establishing a stable AuM base.

A significant majority of private debt asset managers have pursued acquisitions or strategic alliances with life insurers and annuity providers to access it. Such partnerships serve as powerful catalysts for sustainable growth and enable the managers to secure continuous fee streams.

Examples of large-scale transactions include Apollo's acquisition of Athene, Blackstone's acquisition of Allstate Group's Life business and a stake in AIG's Life business, and Ares' acquisition of the F&G Insurance business.

Numerous smaller to mid-sized transactions of a similar nature have also taken place. We anticipate private debt managers will continue to seek opportunities to acquire insurance assets, expanding their exposure to permanent capital, thus ensuring greater flexibility for deploying funds and optimizing returns without liquidity constraints.

Another significant trend is the consolidation of mid-sized private debt franchises through mergers. This allows firms to leverage enhanced scale and gain a stronger competitive edge.

A recent example is the acquisition of Arcmont Asset Management, a Europe-focused private debt asset manager, by Nuveen, which also owns Churchill Asset Management, a US-focused private debt firm. This transaction offers several benefits to a combined entity (Nuveen Private Capital), including enhanced scale for pursuing mid-market and larger deals, access to capital facilitated by TIAA (the largest global allocator to private debt), and improved distribution capabilities, particularly within the wealth channel.

These benefits are expected to push similar-sized private debt firms to explore M&A opportunities with entities having comparable AuM, to gain scale in a challenging environment.

3. New sub-asset classes gain currency

While direct lending is often used interchangeably with private debt, it is essential to recognize that the former is a subset of the latter, accounting for less than half of the overall private debt AuM.

The remaining AuM is distributed among other sub-asset classes, including mezzanine, special situation, distressed, venture, trade/bridge and more recently, secondaries. Given the macro environment and shifting investor preference, we see these classes gaining prominence, especially mezzanine and secondaries.

Global mezzanine funds had a remarkable 2022, raising a staggering $30.1 billion (16% of total capital raised by private debt funds), according to Preqin — or twice the 2021 number, and the highest fundraising volume since 2016. The surge in interest can be attributed, at least in part, to the scarcity of senior debt and unitranche loans.

The prevalence of MFN (most favored nation) clauses in recent first-lien loan agreements has played a significant role in this trend, since it restricts borrowers from accessing new debt with more favorable terms than those already offered to existing lenders. Consequently, opting for new senior debt without repricing the entire first-lien facility has become unattractive, especially in the face of higher prevailing interest rates. Hence, borrowers are embracing the mezzanine route to fulfill additional capital requirements.

Positioned between senior debt and common equity within a company's capital structure, mezzanine has surged due to its potential for enticing interest returns. This makes it an appealing option for investors seeking calculated risks and higher returns. Furthermore, the recent turbulence within regional banks has created additional investment opportunities for mezzanine lenders, further enhancing the allure of this dynamic sub-asset class.

Until just a few years ago, private debt secondaries as a sub-asset class was virtually non-existent, with annual volumes barely reaching the billion-dollar mark. However, private debt has attained critical mass, fulfilling the primary criteria for the secondaries market to flourish.

Recognizing its immense potential, influential asset managers such as Ares and Coller Capital successfully launched dedicated private debt secondaries funds, further feeding the sub-asset class. The impact has been noteworthy, with private debt secondaries volumes reaching an impressive $17 billion in 2022.

Looking ahead, industry experts from Pitchbook estimate secondaries’ deals could soar to $50 billion by 2026.

We see the next phase of growth for this sub-asset class propelled by increasing secondary sales by limited partners (LPs) aiming to rebalance portfolios, especially in an environment of elevated interest rates.

Additionally, the denominator effect, where the public holdings of a portfolio decline in value while the values of private assets remain stable, has resulted in investors being overallocated to private markets.

This increases the need for LPs to consider secondary sales of private debt to adjust their portfolio allocations.

4. Integration of ESG considerations

Mere compliance with ESG regulations is no longer sufficient for private debt investors. Today, private debt asset managers are expected to actively embed ESG principles, a recognition of their unique capacity to shape the ESG performance of portfolio companies unlike other credit investors. This advantage stems from two key factors.

First, private debt asset managers make substantial and long-term investments, providing long-term capital to make transformational changes for the businesses.

Moreover, private credit lenders may secure board representation, granting them leverage to drive meaningful change within portfolio companies. Second, there exists an ESG resource gap among targeted borrowers, particularly middle-market companies, which often lack internal ESG functions and long-term strategies.

However, sophisticated and scalable private debt providers possess the capability to offer not only capital but also valuable resources to portfolio companies and sponsors. By doing so, they actively enhance a company's ESG maturity and establish concrete sustainability targets that seamlessly align with the broader business strategy.

In this context, private debt asset managers are proactively responding to the twin forces of rising investor demand for ESG integration and the increasing interest of borrowers. They are adopting innovative approaches to incorporate sustainable practices into their investment strategies.

An example is the utilization of sustainability-linked loans (SLLs), where the interest rate is tied to attainment of pre-defined sustainability objectives. This incentivizes the borrower to achieve tangible sustainability outcomes while allowing asset managers to leverage capital and resources to fortify businesses.

The utilization of SLLs is expected to become increasingly widespread in the future. While Europe is currently leading in terms of engagement, there is a noticeable shift in the US among private equity firms.

As more of these loans are arranged and data begins to emerge, the industry will witness the evolution of best practices and a deeper understanding of their impact. 

Conclusion

Private debt asset managers are embracing new trends to forge ahead. By staying ahead of the curve, they can position themselves for greater success in future, attract new clients and deliver strong performance.