Some say private credit hasn’t been tested. We disagree…and stress can sharpen the senses.
The last few years have delivered plenty of stress for investors. First, a global pandemic—then a sharp rise in inflation and interest rates. Sweeping US tariffs on a lengthy list of goods surprised markets in the spring, with wide-ranging effects on the global economy and investment landscape.
Because prices in public markets are more observable, these shocks have translated into sizable bouts of volatility across equities and fixed income—including credit. As has been widely discussed in the press, private market volatility has seemed relatively muted—but that doesn’t tell the whole story. Now, with equity indices rebounding to new highs, inflation declining, and stability seemingly taking hold, some might conclude it's back to business as usual.
Quite the contrary. If anything, the past five years have underscored that private credit is not immune to market cycles. But periods of stress often yield lessons—and opportunities—for nimble investors willing to adapt.
As we reflect on recent events and beyond, here are five key takeaways:
1) It’s All About the Alpha
Corporate direct lending isn’t exotic anymore. Today, it's a core allocation within many diversified fixed-income portfolios. While performance across the asset class has been strong over many years—largely supported by accommodative monetary policy—it’s misguided to believe that a rising tide will continue lifting all boats.
One defining feature of the US corporate direct lending market is its fragmentation: different sectors, sponsors, sizes, structures and solutions, with direct lenders competing for deal flow within and across these segments. Based on a recent S&P Global analysis of middle-market collateralized loan obligation data, the percentage of portfolio holdings that managers have in common remains extremely low. Simply put, not all direct lenders are alike. Channels for originating deals, underwriting approaches, sector preferences and, as a result, the companies in portfolios vary quite a bit.
As default rates and other signs of stress emerge across this asset class, the impact is anything but uniform across companies and managers. In short, consistent historical returns may have fostered a perception of private credit as a beta-driven market—but looking ahead, we believe alpha will be the key differentiator.
2) Recurring Revenue: It’s Not Created Equal
We’ve long believed in the value of lending on a recurring revenue basis to Software-as-a-Service (SaaS) providers that offer critical solutions for enterprise resource planning. However, not all recurring revenue is created equal, and revenue quality demands careful attention.
As interest rates and the cost of capital soared, the surge in tech spending that began during the pandemic—when employees shifted from office to home—began to wane. Elevated rates also compressed SaaS company enterprise values, tempered growth trajectories and pressured customers, many of which began scaling back spending on software licenses.
Many lenders that extended too much leverage during the low-rate environment have learned this lesson the hard way. From our perspective, this experience is a clear example of a high-growth sector where underwriting experience and generating alpha through asset selection are more important than ever. Lenders must first identify businesses with resilient value propositions and a demonstrated ability to navigate cycles—then calibrate loan sizes accordingly.
3) Disruption Once Again Breeds Opportunity
Here’s a revealing stat: private equity funds distributed just 14% of their net asset value (NAV) to investors last year, down from an average of 28% per year from 2015 through 2020 (Display). Macro headwinds—including rising rates and political uncertainty—have dampened M&A activity and price discovery. As private equity continues to mature as an asset class, and with both general partners (GPs) and limited partners (LPs) seeking liquidity, private fund finance has grown across a variety of structures. These range from traditional capital call facilities to more innovative solutions such as GP- and LP-led secondaries and continuation vehicles.
With banks still under pressure, alternative lenders have been driving this growth, and fund finance has become a rising allocation in investors’ portfolios.
