Private Debt Juggernaut Continues Apace

November 13, 2024
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On November 7th, the US Federal Reserve cut the Federal Funds rate for the second meeting in succession. The target range is now 4.5% – 4.75%, a 25 basis points drop from September, which itself delivered a 50 bps reduction from the recent high of 5.25% – 5.5%.

Good news and not so good news for private debt funds, of course.

The good: A lower cost of capital should mean, other things being equal, more deal activity as the US small and mid-market looks to take advantage of lower borrowing costs. Also the good: Lower rates supports fundraising as investors see liquid fixed income as less appealing, so we should see some rotation out of liquid fixed income and into private debt going forward. Indeed, an uptick in asset gathering for the space has already begun, with third quarter fundraising for private debt delivering the strongest quarter since Q4 last year.

The not so good: Lower returns on existing floating rate loans, and lower returns going forward. Right?

Not necessarily. Preqin recently published a forecast for the global alternative investment industry, suggesting that overall assets under management will rise to almost $30trn in 2029, up from $16.8trn at the end of 2023, a huge 74% increase in just six years.

But that very same forecast suggests that the average IRR is expected to rise to 12% over the 2023-2029 period, up from 8.1% during the six years from 2017-2023.

There are, of course, a myriad of reasons why this might be the case. Lower interest rates can encourage companies to seek more financing, leading to an uptick in private debt deals. With higher volumes, private debt funds can be more selective, focusing on high-quality borrowers or structured deals that yield higher returns.

Despite lower base rates, private debt funds often include credit spreads. As some companies face higher risks or market uncertainties, lenders may command higher spreads, boosting overall yields on loans even if the underlying rates are low.

Private debt managers may use creative structures, such as subordinated or mezzanine debt, to achieve higher yields. These deals often come with added risk but can deliver better returns. Funds may also secure equity kickers or warrants, adding a potential upside.

Lower-rate environments sometimes bring distressed debt opportunities, particularly if some firms have over-leveraged. Funds focusing on this space, or on undervalued assets, can capture higher returns as the companies recover; interestingly, Preqin suggests that distressed debt IRRs will hit 13.4% (same hyperlink as above).

As the sector grows, some funds gain scale efficiencies, enabling them to reduce operational costs. Lower costs improve net returns for investors, which may allow funds to achieve a higher IRR target without necessarily increasing gross yields.

Finally, with lower borrowing costs, private debt funds themselves can leverage their capital (similar to banks), amplifying returns on equity invested (this can also increase risk, as leverage magnifies both gains and losses, of course).

I’ve said before that I think that private debt funds genuinely earn their money. In a lower rate environment, that’s certainly the case, as they will have to work harder and smarter to get those IRRs up to the levels suggested by Preqin.

But the space has the opportunity and flexibility to get there. I have been in this market since not long after its emergence in the post-Global Financial Crisis period, and I’ve diligenced hundreds of funds with a range of underlying exposures. I’ve seen it learn some (tough) lessons and grow and mature to a point where it is now a permanent feature of a diversified portfolio.

There will always be instances like this one where a restructuring of the debt of a large borrower might be necessary, or worse, where the lender defaults. But no asset class has ever batted 1.000, and generally, the outlook for the space is positive – regardless of the prevailing interest rate environment.

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Gregory Poapst is a Managing Partner at Fundviews Capital. Connect with him on LinkedIn here.

Fundviews Capital is a full-service end-to-end Fund Management Platform.  Our platform provides a complete end-to-end solution for asset managers or wealth managers to structure, launch, operate and grow their professional investment funds. You can launch a fund in a matter of weeks, not months, and with minimal capital outlay – not only reducing the risk of launching a fund but also maximizing your chance of success. Once launched, you will find that a dedicated team of professionals is just a phone call or email away at all times, handling all aspects of the back and middle office for your fund.

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