Competition, dealflow and defaults

The following is an extract from our 2025 global outlook.

Private credit demonstrated remarkable resilience in 2024, despite high interest rates. Performance has been strong across both investment grade (IG) and sub-investment grade (sub-IG). With more rate cuts expected on the horizon, we believe future returns are likely to be lower. We still think, however, the all-in yield (about 5-8% for IG, 8-12% for sub-IG debt) should be attractive in comparison to the very tight spreads in public credit.

New issuance activity was buoyant in 2024. Both IG and sub-IG markets recorded notable year-on-year growth. Decarbonisation and digitalisation have been the leading force in driving opportunities across renewables, data centres, power networks, transportation and social infrastructure. We expect this to continue into 2025 and beyond, driven by the huge capex needs of the green and digital transitions (for more, see Aanand’s piece).

Market competition

A recovery in bank lending in 2024 has increased competition. The pressure is more acute in sub-IG, where asset managers are trying to deploy over $400bn of dry powder[1] in what we see as a weak M&A environment (a big proportion of sub-IG private credit deal activity is driven by private equity transactions). This has led to a significant compression in direct lending spread over 2024 and, in our view, raises the risk of lenders underwriting riskier deals which could create problems in future years.

We expect a revival in M&A activity in 2025, supported by deregulation under Trump and further rate cuts. This should, we believe, tilt market dynamics in favour of private credit lenders, as an increase in investment opportunities is likely to reduce the pressure on credit spreads. However, given the general macro uncertainty and competitive pressure from banks, we stress the importance of robust underwriting and structural protection and being sufficiently rewarded for any risk taken.

Wary of complacency

Defaults in sub-IG private credit have been, in our view, surprisingly low given elevated interest rates – most indicators range between 2% and 4%[2]. Strong earnings growth and cost management are the primary drivers. Another contributing factor is the increasing use of payment-in-kind (PIK), which has helped borrowers conserve cash and avoid defaults. While the use of PIK is not necessarily a sign of financial distress, we are wary of complacency. Trump’s re-election has, in our view, raised the risk of higher debt costs for longer. We don’t believe borrowers who over-leveraged during the pandemic years are completely out of the woods yet.

Finally, 2024 was the year that private credit lenders joined arms with banks as they looked to additional growth avenues. Many partnerships have been announced, most notably the $25bn direct lending programme between Citi and Apollo. The ‘coopetition’ model should, in theory, allow banks to retain client relationships and offload balance sheet unfriendly assets. Private credit lenders can leverage banks’ enormous network and underwriting expertise, enabling diversification into a broader array of asset classes and a wider client base.

Good risk management will be core to the success of these partnerships, in our view. However, they could expand capital to parts of the economy underserved by banks, therefore proving a positive for growth in GDP and the asset class generally.

The above is an extract from our 2025 global outlook.

 
[1] Source: Preqin, as at November 2024
[2] Source: Proskauer, Goldman Sachs, KBRA