Rise of private debt creates fears of a bubble

Nature is said to abhor a vacuum, but finance loves them. After all, they tend to be very profitable — at least for savvy early movers.

Banks have in recent years been forced to retrench their operations, tamed by financial crisis losses, bridled by shareholders and tethered by more onerous regulation. Lending to smaller and mid-sized companies has been one of the biggest victims, as banks have focused on servicing their blue-chip clients. But a swelling array of investors have stepped into the resulting breach.

So-called private debt funds act much like a bank, making loans to businesses too small to go to the bond market, but too big to simply rely on a loan facility from their neighbourhood credit union. It is an eminently sensible and useful business model, marrying the corporate need for funding with institutional investors’ desperation for higher returns at a time interest rates have plumbed historic lows.

But some industry insiders are beginning to worry that private debt is getting frothy, as billions of dollars roll into a once-niche market. The discipline and juicy returns that characterised the private debt world just a few years ago have been significantly eroded. Today, “if you can breathe fog in a mirror you can get a loan”, says the head of one asset management firm that looked at setting up a private debt fund but decided against it, given the frothiness.

Private debt is a large and diverse ecosystem, made up of asset managers, private equity firms, pension funds, insurers, “business development companies” and hedge funds. The assets under management of private debt fund managers tracked by Preqin have increased fourfold over the past decade to $595bn at the end of last year, after another 131 funds raised $93bn in 2016. At the current growth rate, the data provider reckons the industry could reach $2.5tn in another decade — rivalling the private equity world.

Admittedly Preqin’s classification includes more hedge fund-like strategies like “distressed debt” and “special situations”, typically funds snaffling up the loans of a company in or about to go into bankruptcy, betting that the recoveries can be greater than the beaten-up cost of the debt. But direct lending is the biggest and fastest-growing chunk, and boasts big players like Goldman Sachs, Oaktree Capital and Apollo Global Management.

The investor enthusiasm is palpable. More than 90 per cent of investors polled by Preqin said their private debt returns met or exceeded their expectations, and 62 per cent plan to increase their allocation over the long run. That made it a more popular asset class than more traditional alternative allocation stalwarts like real estate, infrastructure, natural resources and private equity.

But returns have been souring lately. Preqin’s latest median net internal rate of return — a popular industry measure of performance — for direct lending funds set up in 2010-14 has gradually dipped from 10.6 per cent for the 2010 vintage, to 7.6 per cent for 2014 vintage funds. One analyst says that while a private debt fund might reasonably expect to collect an interest rate of 10-12 per cent five years ago, a similar loan would only pay 5 per cent to 6 per cent today, as a result of all the money gushing in.

The industry itself is becoming a little warier. Almost half of fund managers polled by Preqin said valuations were a big problem, with 31 per cent citing deal flow and 27 per cent highlighting fee pressure. On the other hand, only 3 per cent due diligence on their lending was a “key challenge”.

It is too early to call time on the private debt binge. The economy is ticking along nicely, quelling any corporate distress, and the amount of money chasing potential borrowers will paper over many cracks. But when the business cycle inevitably at some point rolls over, many investors will discover that the interest rates they are now charging are inadequate compensation for the risks.

Smaller companies are more vulnerable to economic and technological cycles than bigger counterparts, and tend to have fewer assets that creditors can seize in a bankruptcy. The loans are incredibly hard if not impossible to trade, so if a company goes kaput then private debt funds exposed to the mess will be locked in and likely suffer terrible recovery values.

This is a story as old as capitalism itself. A promising new market proves phenomenally profitable, attracting more players and eventually some tourists. Returns are eroded, standards fall and eventually it ends in tears. Private debt has a vibrant future, but there will be some bumps along the way.

robin.wigglesworth@ft.com