Private debt – strong performance in the face of uncertain times: The Pitchbook Global Private Debt Report H1 2023

On 25 September 2023, Pitchbook published their Global Private Debt Report (Report) on H1 2023 activity in the private capital markets. Whilst the Report is US-centric (and the figures reported are from the US market), we are seeing broadly similar trends emerging in the UK and Europe.

Pitchbook characterise the first half of 2023 as a period of robust private debt fundraising activity which saw continued interest in a diverse range of private debt strategies. In particular, the Report highlights the following.

1. Continued interest in private debt strategies amongst international investors, with H1 2023 fundraising commitments standing at $94.9bn as against $91.4bn for the same period in 2022.
   
   The extent of H1 2023 activity in this space, and the fact that the second half of the year is typically the stronger of the two – a trend that is likely to be played out this year given the stockpile of dry powder currently held¹ – suggests that 2023 will be the fourth year in a row with new institutional commitments above $200bn; this notwithstanding a slowdown in retail fundraising in the US and a potential return of syndicated bank loans.
   
   We see this widening of the markets readily evidenced by, among other things, the rise of club deals, with direct lenders once focused on standalone financings capping out in the €200m ballpark now clubbing together to finance loans typically the purview of the syndicated markets, and a new wave of mid-cap funds as established players have moved to large cap deals with the increasing retrenchment of bank lenders historically dominant in the space. Those new players are also open to sharing deals so as to participate in a more diverse portfolio and build their track record faster.
   
   Pitchbook further note that in the US markets two of the top ten funds closed in H1 2023 were closed by emerging managers – being those managers with three or fewer funds – and that generally emerging managers accounted for 12.8% of the market in H1 2023 compared to 7.5% in 2022. This growth suggests that notwithstanding a general backdrop of a flight to scale², allocators are prepared to select managers on the basis of their specialised or differentiated approaches (for example those relatively few Article 9 credit funds³), and not simply on the basis of their size and track record. Indeed, in the volatility of the current high interest rate and high inflation macroeconomic environment it may be considered advantageous to be absent of an existing, potentially stressed, portfolio (and some new entrants to the market are certainly marketing themselves as absent of portfolio distraction). This appetite for differentiation also rings true in Europe where, notwithstanding that forecasts suggest that there will be tougher conditions for emerging managers in H2 2023, specialised or differentiated approaches are heralded as the key to attracting commitments and some new mid-market managers have managed to withstand the headwinds and raise first funds.
    
2. The strength of private debt strategies in the current markets. 
   The Report notes that in H1 2023, for the first time since 2013, private debt strategies consistently outperformed most other private market strategies (save for real assets and real estate) and the S&P 500 – where stock and fixed income investors saw losses of 18.1% - having benefited from floating-rate structures and diligent underwriting amid a rising interest rate environment. PitchBook’s final estimate of fund performance is that private debt funds returned 4.2% in H1 2023. On the other hand, increased performance has driven new entrants and increased competition amongst established GPs, which in turn has led to pressure on fundraising and fees in the estimated $1.5tn private credit sector.
    
3. The continued importance of retail fundraising as a growth vector for private credit managers notwithstanding increased competition in the space and that retail fundraising slowed in H1 2023.
   
   Despite a fall in the volumes of US retail fundraising with H1 2023 seeing an estimated $16.6bn being committed, a quantum someway below the 2022 quarterly average of $12.0bn, the number of product launches has increased significantly as sponsors try to emulate the success of Blackstone’s Private Credit Fund. While some lenders look to closed ended funds, other sponsors are launching alternative (evergreen) retail vehicles, such as interval funds and business-development companies, the latter path recently trodden by T Rowe Price and Oak Hill Advisors who have together launched the T Rowe OHA Select Private Credit Fund. While sponsors have tapped into the vast potential of the US retail market, entering the UK/European retail landscape presents its own set of challenges. Not only is the latter smaller in size, but it's also grappling with regulatory reforms like MiFID II, aimed at enhancing transparency and reshaping distribution channels. As a consequence, some innovations that gain traction in the US might initially find their footing in the UK/European institutional segment. Two notable and innovative institutional products are the evergreen European direct-lending funds launched recently by KKR and Carlyle. Neither of these funds will charge carried interest or any form of performance fees. It will be interesting to see whether this is the beginning of a broader trend of managers prioritising asset accumulation over performance-based rewards⁴.
    
4. Diversity of strategy with direct lending and mezzanine funds accounting for 32% and 27.9% respectively of the funds closed in H1 2023.
   
   Whilst certain strategies are clearly preferred options in certain sectors - with for example direct lending continuing to be the preferred financing option for large leveraged buyouts, especially in the middle market, as banks remain cautious and selective in the syndicated loan market – the increasingly dynamic landscape highlighted by the Report is exemplified by the strategies of the top private debt funds closed in H1 2023, which funds cover the breadth of mezzanine, special situations and direct lending. Macfarlanes are seeing this in practice with managers establishing funds with differentiated strategies from their flagship senior loan or direct lending funds, and often very specific strategies (such as healthcare, infrastructure, fund NAV and leverage lending, impact investing, etc.). This opens up a wider spectrum of deployment opportunities, whilst also playing to the different appetites of the LP investor base to which they market. Finally, it remains to be seen the role of continuation funds, which only continues to grow in the context of private equity, will play in this asset class – private debt, by its nature, often has shorter durations than private equity investments. However, given the evolving nature of the private credit market and its increased complexity and diversification, there's potential for such liquidity solutions to be explored in private credit, especially for longer-duration or more illiquid credit strategies⁵. 

¹ Preqin data shows an increase in private credit dry powder from $412.2bn in December 2022 to $438.1bn as of June 2023.

² Notable launches in H1 2023 included Ares, with two funds (including Ares ACE VI) seeking a total of $15bn, including its third direct lending fund.

³ Funds that fall within Article 9 of the Disclosure Regulation (Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability‐related disclosures in the financial services sector), being a fund that has sustainable investment as its objective. Where sustainable investments are defined in the Disclosure Regulation as: (i) investments in economic activity that contributes to an environmental objective; (ii) investments in economic activity that contributes to a social objective and in particular an investment that contributes to tackling inequality, an investment fostering social cohesion, social integration or labour relations; and (iii) investments in human capital or economically or socially disadvantaged communities; provided that such investments do not significantly harm any of those objectives and that the investee companies follow good governance practices, in particular with respect to sound management structures, employee relations, remuneration of staff and tax compliance.

⁴ For further Macfarlanes commentary on the commercial pressure on remuneration for private credit funds in the context of rising interest rates, see our two part series: Are private debt hurdles rising? - part one - Macfarlanes.

⁵Ares launched a debt secondaries business in March 2023 and this month closed its first credit-secondaries deal, a $166m continuation fund involving NXT Capital.