Partner Insight: Private credit outlook - Room to run

In this quarter's outlook, we weigh short-term challenges against the long-term secular trends likely to support continued growth in private credit.

A steady climb in interest rates in 2023 has dampened merger activity and private transaction volume. But a higher-for-longer interest-rate environment may mean fewer surprises ahead for investors, and we expect deal activity to rebound with relative stability in rates. Growth may slow, but the US and European economies have remained remarkably resilient despite multiple shocks, including a regional bank crisis and high energy prices. 

Higher rates mean lenders today can extract higher returns, which come on top of the illiquidity premiums associated with buy-and-hold private credit investments. We've seen a modest pickup in deal activity lately that should persist as the year winds down and uncertainty about the path of rates and inflation recedes.

To put it plainly: we think there's still room to run.

Bank Withdrawal Bolsters Private Lending Opportunity

Private credit has grown rapidly in recent years as banks began to retreat from certain types of lending (Display). Increased volatility in public markets and growing investor interest in and comfort with private financing have helped accelerate the trend.

And since interest rates began to rise last year, more than $1 trillion of household deposits have left the US banking system, according to the US Federal Reserve Board. That departure adds momentum to the trend of bank retrenchment that began after the global financial crisis—one of many secular trends that transcend economic cycles.

The exodus gathered momentum after several high-profile US regional bank failures in March, forcing banks to shore up capital and reduce lending even further. Many face higher capital requirements and increased regulatory scrutiny, which has prompted them to reduce risk in stressed sectors, sell assets and search for partners to provide financing to their customers.

At the same time, public markets are getting smaller. In the corporate space, companies are increasingly foregoing initial public offerings and turning to alternative sources of capital. All of these trends are creating short-term and long-term opportunities across the risk-return spectrum. 

No Time Like the Present

Let's start with where investors can dig in today. Interest rates are high and likely to stay there, and a recession can't be ruled out in the US and Europe. We believe a protracted period of slower growth and market disruption plays into the hands of opportunistic credit strategies with experience navigating tight credit environments. 

Investors may be able to capitalize on these dynamics by acquiring discounted consumer and commercial loans from banks eager to reduce risk and raise liquidity. For insurance companies and other investors who source capital from customer premiums rather than customer deposits, it may present an opportunity to take over direct origination of a wide range of loans.

We also see opportunities in lending against specific pools of consumer and commercial assets with idiosyncratic cash flows, including residential mortgages, or receivables. Weighing in at more than $5 trillion and growing, this specialty finance market—sometimes referred to as asset-backed lending—is bigger than those for direct lending and private equity combined and comes with diversification benefits and attractive risk-adjusted return potential. But it remains underrepresented in many portfolios.