Rising interest rates and tighter bank lending standards are shifting institutional investors' attention to private credit strategies as private equity performance falters in a challenging exit environment.
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Global private credit assets under management were a record $1.37 trillion at the end of 2022, according to Preqin Ltd. estimates, and are forecast to grow nearly 9% to $1.49 trillion by the end of 2023. While private equity funds draw significantly more investor capital than private credit funds globally, the gap narrowed between 2019 and 2022, according to Preqin data.
"The fundamental thing that has changed is the relative value of private credit versus private equity," said Jeffrey Griffiths, co-head of global private credit for Campbell Lutyens & Co. Inc.
If interest rates remain higher over the long term, instead of shifting back to the near-zero rate environment of the previous dozen years, it will likely prompt a reshuffling of private equity limited partner portfolios, Griffiths suggested.
"I think that you'll start to see those private credit allocations bump up higher, and you might see that happen at the expense of the private equity allocation," he said.
Steady rise
Private credit, also known as private debt, includes a range of nonbank lending strategies, and many large alternative asset managers raise private credit funds alongside their private equity funds. Private credit produces lower returns than private equity, yet it is viewed as a safer bet by risk-off investors who also stand to see better returns from the asset class after central banks began hiking interest rates to combat inflation in 2022.
Private fund investors, known as limited partners (LPs), committed 5.6 times more capital to private equity than private credit in 2019. However, the gap narrowed each subsequent year through 2022, when the figure was less than 3.9 times.
"The large LPs have been steadily committing [to private credit funds] basically for this moment, which is really private credit's time to shine. We're seeing them sort of double-down on their interest in the asset class," said Pete Witte, global private equity lead analyst for EY.
"At the same time, you have investors that haven't committed significantly to private credit before [and] all of a sudden they're seeing all of this activity in the space and wanting to make sure that they're involved here as well.”
Recent momentum
The dynamic between private equity and private credit was a topic on the first-quarter earnings calls of several large alternative asset managers.
In the first quarter, inflows to The Carlyle Group Inc. "skewed further toward global credit and investment solutions and less from corporate private equity," said CFO Curt Buser, adding that the difficult private equity fundraising environment meant buyout funds in the market could end up smaller than their predecessors.
Investors are showing the "greatest demand" for credit among Blackstone Inc.'s array of strategies, said President Jonathan Gray.
"Coupled with the pullback in regional bank activity, this is a golden moment for our credit, real estate credit and insurance solutions teams, which accounted for 60% of the firm's inflows in Q1," Gray said.
Ares Management Corp. CEO Michael Arougheti contrasted the rising appeal of private credit among LPs with the constraints those investors are facing on their private equity allocations. Private equity exits are down in a slow M&A environment, which has tightened the flow of distributions to LPs and limited their ability to commit new capital to the strategy.
"We are seeing from investors, I don't know if I would call it reduced appetite for private equity, but reduced ability to invest in pure, regular-way private equity," Arougheti said.
Portfolio shifts?
A return to healthy exit activity should boost private equity fundraising, eventually, Witte said. But he does not anticipate private equity and private credit jostling for space in limited partner portfolios when that happens. Allocations to both asset classes are more likely to grow side by side, he said, noting private credit is a "complementary" investment to private equity since it is still largely used to finance private equity deals.
"You're just supporting those deals on the debt side at the same time that you're supporting them, from an LP's perspective, on the equity side. It's two passes at the same asset, and just different pieces of the capital stack," Witte said.
Glenn Mincey, head of KPMG LLP's private equity practice also believes investors are looking to boost their private credit allocation alongside an existing private equity allocation. Private credit is "just one more tool in the toolkit" for asset managers to provide returns to their LPs.
Mincey said private credit funds have been growing in size since the aftermath of the 2008–2009 global financial crisis, when increasing regulatory constraints on banks "really pushed the need for private lending." Now that private credit's breakout moment has arrived — a moment that coincided with the collapse of three regional banks in the US — alternative asset managers are eyeing more opportunities to partner with regional banks or even edge into the banks' territory, developments that will potentially accelerate private credit deployment and fundraising.
"Private credit will need to grow outside of the private equity world more, and it is doing that," said Griffiths with Campbell Lutyens.
"And if it does do that, and if you were to imagine the banks doing a lot less lending, then you could see a world where private credit is bigger than private equity because the opportunity to lend money is huge. It's just enormous."