Large pension fund investors have increased their allocations to private credit in memory of how the asset class performed post-global financial crisis.
Last year, private credit assets under management exceeded $1 trillion for the first time. Over the next five years that figure is expected to more than double.
On an earnings call at the end of October, Blackstone’s COO Jon Gray described private credit as a “long-term mega trend” within alternatives, which has been experiencing mega-trend status itself for almost a decade. Gray has reason to be positive: Blackstone’s Q3 earnings showed private equity shedding 0.3% in value during Q3, compared to a 2.1% increase net returns for private credit. “I don’t see any of sort of large-scale movement away from this very attractive asset class,” he said.
He might be right. Pension funds, insurance companies, and endowments have been willing to assume greater credit and illiquidity risk in exchange for higher returns, said Moody’s earlier this year. In a more volatile economy, they are expected to show even more interest in the asset class, rather than less. Fifty-seven percent of institutional investors plan to increase their allocations to private debt over the next three years, according to a survey by SS&C Intralinks at the start of this year. The figure is likely to be much higher now.
“Investors also have long memories, and they remember that the [private credit] vintages raised in the aftermath of the GFC performed incredibly well,” says Jonathan Bray, partner at Clifford Chance, who works with some of the world’s largest credit funds.
Pensions have been the largest allocators to private credit by dollars invested and hold an average allocation of around 3%, but some allocations are now much higher. This year the largest public pension fund in the US, the California Public Employees’ Retirement System, increased its asset allocation target for private debt to 5%, from 0%. The Arizona Public Safety Personnel Retirement System has a 20% target asset allocation for private credit. Insurers are also expected to add private credit to their portfolios, though at a more gradual pace, and high-net-worth investors are also allocating a higher percentage of investment capital to private credit.
Fundraising is currently on par with its peak in 2021, according to PitchBook. Managers raised $82bn across 66 funds in the first half of this year. Direct lending – which tends to benefit from rising interest rates by using floating rate instruments and has comparatively lower volatility – continues to be the standout strategy, accounting for more than a third of capital raised in the first half of the year, but special situations funds and real estate debt funds also received plenty of attention.
“We’re seeing investors come down the risk curve a bit and shifting some of their equity allocation into mezzanine funds and some of the people who have been heavily into mezzanine funds move down to direct lending funds so there’s a bit of movement within the asset allocation,” says Bray.
While it is now rare to see a private credit fund below $1bn in target size – Blackstone’s credit vehicle focused on renewable energy and the energy transition is targeting $7 billion next year – people in the market sees the potential for smaller niche strategies within the asset class as banks retreat. Debt funds providing revolving credit facilities could be the next trend here, following distressed or sector-specific vehicles, says one debt fund source. A scarcity of private credit solutions in the 250-500 bps range could also create an additional opportunity set for direct lenders, according to Deloitte’s Private Debt Deal Tracker.
Stafford Capital Partners launched the Private Credit Income Opportunities Fund in October, a new open-ended fund split equally between direct lending and speciality finance. The direct lending arm will focus on senior secured debt in the lower middle market, while the speciality financing will target assets with low market correlation, which could include music royalties, says managing partner Rick Fratus.
Fratus sees an opportunity for increased deployment from co-investing LPs, particularly from well-funded Australian pension funds, but acknowledges there is a risk where they might be invested on the equity of a transaction already.
In terms of traditional fundraising, more growth is expected to come from Europe in the coming years than North America, which is considered to be the more mature private credit market. Between 2013 and 2020, Europe represented 43% of direct lender fundraising, compared to 51% from North America, according to Deloitte.
And much like the fund consolidation that has taken place across private equity, larger credit funds are already dominating: almost half of all the capital raised by private credit managers last year was taken in by the ten largest funds, according to Preqin, with the number fundraising dropping from 255 to 202.
The largest direct lending fundraise in Europe last year was Ares Capital Europe V at over EUR 11 billion which included institutional investors California Public Employees’ Retirement System, Virginia Retirement System and Maine Public Employees Retirement System, according to Bloomberg. Next year Ares should go further when it launches Ares Capital Europe VI at the beginning of the year.
As a result, the average credit fund size grew from $663 million in 2020 to $958 billion in 2021. Direct lending funds tend to be even larger. This growth in fund size is a positive fundraising signal but it is also significant because it allows direct lending funds to compete more easily with syndicating banks on larger buyout transactions, where ticket size is an important consideration for sponsors. Indeed, traditionally, the challenge for private debt funds has deployment rather than fundraising. With banks in retreat from leveraged buyouts for now, many direct lenders sense opportunity to deploy at a faster rate.
“Direct lenders in Europe had become more comfortable earlier this year with providing financing on looser, more flexible terms tailored to borrower requirements for bigger deals,” says Colin Harley, a London-based partner in the White & Case Global Debt Finance Practice, adding that the current market volatility, and accompanying lack of competition from the syndicated loan market on larger deals, has brought those looser terms under greater scrutiny once again.
In Europe, it is the UK which leads as the main source of deal volume for direct lenders, followed by France and Germany. Deal volume here is trending down year-on-year but a flurry of activity is expected from overseas buyers following a weakened pound and depressed valuations. The current generation of direct lenders in fundraising will be watching closely.
