(Editor's Note: Private Markets Monthly is a research offering from S&P Global Ratings, providing insightful interviews with subject matter experts on what matters most across private markets. Subscribe to receive a new edition every month: https://www.linkedin.com/newsletters/private-markets-monthly-7119712776024928256/)

Whether private or public, credit is credit. S&P Global Ratings has comprehensive and broad insights into the private credit market--with our ratings analysis and coverage of private debt, alternative investment funds (AIFs) and asset managers, leveraged finance and collateralized loan obligations (CLOs), structured finance transactions, insurance companies, credit estimates, and business development companies (BDCs). Looking ahead to next year, we expect opportunities for private credit and funds to remain robust, after booming in 2023. Challenges for borrowers may be opportunities for lenders.

As investors increasingly allocate capital across the private debt markets, evolving macroeconomic and financial conditions may necessitate a need for greater transparency. In this edition of Private Markets Monthly, Head of Thought Leadership Ruth Yang interviews eight S&P Global Ratings' subject matter experts on what matters most across private markets to provide our perspective on conditions and trends to watch for the year ahead.

Private Credit Is Likely To Continue To Grow, But More Slowly

Andrew Watt, Head of Financial Services, Infrastructure, & Alternative Asset Ratings for the Americas:  While we expect private credit markets to grow, the pace will slow as markets navigate uncertainty around the direction of interest rates. We expect to see the continued trend of larger issuers tapping the private credit market for their capital requirements--and anticipate solid growth in middle-market and private credit CLOs, alongside alternative asset managers and insurance companies continuing to allocate funds to private credit.

David Tesher, Head of North America Credit Research:  Looking ahead to 2024, it's natural to think about emerging risks in the private markets--and the key risks associated with private credit are generally the same as those for the public debt markets. How these risks manifest depends on where a borrower is in its life cycle and, equally as important, on broader credit conditions. For North America, we think tight financing costs, the potential for a U.S. recession, and persistent cost pressures are the preeminent prevailing risks.

Paul Watters, Head of European Credit Research:  We expect the private debt market in Europe to develop in innovative ways in 2024, as the market looks to broaden and deepen--against the backdrop of a macro-credit environment that will require a recalibration of business and financial strategies for many midmarket companies that raised financing from the private debt market prior to 2022. At the same time, higher interest rates and some repricing of risk, combined with tighter underwriting standards in the banking sector, offer potentially attractive lending opportunities for private debt providers.

Andrew Watt:  Ultimately, the pace of the Federal Reserve's "pivot" is an important factor to monitor with regard to the outlook for market growth, as the full impact of higher-for-longer rates has not entirely flowed through issuers' financials and will likely be felt next year. We expect a continuation of downgrades but could see the momentum slow next year--depending on the duration of higher rates. Lenders and borrowers in this market continue to work together to minimize bankruptcies and other traditional payment defaults by executing amendments to waive covenants and address near-term liquidity challenges.

However, other forms of defaults have ticked up. Given the volatility around rates, and asymmetric views on valuation among sponsors, asset sales and private equity exits are being pushed back--resulting in issuers executing "amendments to extend" near-term maturities, which, in most instances, is a selective default, in our view. We've seen an uptick in lenders allowing for a partial or full payment-in-kind (PIK) of interest on their term loans.

Alternative Investment Funds Are Likely To Expand In Number And Leverage

Devi Aurora, Managing Director & Analytical Manager for Financial Institutions:  We believe tailwinds for the proliferation of AIFs will continue, even as existing funds wrestle with challenges, including weak or uneven valuations, a slower ramp-up in fundraising, and rising liquidity needs due to reduced opportunities for exit. Assuming interest rates stay high for much of 2024 and capital markets choppy, AIFs might take on more leverage in order to purchase new assets, return capital to limited partners, and provide support to portfolio companies.

We will keenly watch how leverage builds at funds, assess the likelihood of breaches in loan covenants, and monitor how loan agreements evolve as interest rates stay high--and whether lenders' collateral and security arrangements change if the likelihood of exit opportunities dwindles.

Andrey Nikolaev, Managing Director of Financial Institutions and Alternative Funds for Western Europe:  For 2024, we expect increasing use of leverage by AIFs to support some of the investee companies and the higher share of equity required to do new deals amid high interest rates, alongside growing dispersion between funds and general partners (GPs). We anticipate continued growth for private debt and secondary strategies.

In an environment of still-limited deal and IPO activity, we expect a growing number of funds to turn to net asset value (NAV) facilities and other instruments to finance distributions to limited partners (LPs) in order to improve their distributed to paid-in capital ratios. While dry powder in the private markets remains high, we believe LPs will remain selective and look for stronger track records and diversified offerings among GPs--thereby increasing competition for capital. Given the scarcer capital and funds' difficulty to exit investments quickly, we expect both GP- and LP-led secondary strategies to be in high demand.

Paul Watters:  Innovations will provide greater access to the small and midsize entities (SME) asset class for retail investors and more credit-conscious institutional investors in Europe. Fund managers in the EU are establishing European Long Term Investment Fund (ELTIF) 2.0 vehicles that can include illiquid middle-market lending and subordinated debt, and be marketed to retail investors once the new regulations take effect on Jan. 10. These alternative funds can provide more liquid capital instruments for investors, subject to sufficient notice.

Andrey Nikolaev:  In Europe in particular, we also expect growing cooperation between investment funds and, notably, the largest private debt players and traditional banks--with the former providing capital and benefiting from often higher risk appetite, and the latter offering the knowledge and local presence in the fragmented European markets.

Devi Aurora:  We believe AIFs with low stressed leverage, stable funding structures, strong liquidity features that favor cash traps toward debtholders, and solid track records of performance will remain best positioned to ride out the challenges that 2024 could bring.

Leveraged Finance And Middle-Market CLOs Sought After To Diversify Funding Sources, While BDCs See Volatility In Valuations

Andrew Watt:  The global private debt market, estimated to be about $1.75 trillion (including BDCs, interval funds, and other retail-oriented vehicles), is comparable to the U.S. broadly syndicated loan (BSL) and speculative-grade bond markets. At S&P Global Ratings, we saw this growth in the record number of rated middle-market CLOs in 2023.

Stephen Anderberg, Sector Lead for U.S. CLOs:  Issuance of middle-market CLOs has seen a 120% increase through November compared with the same period last year, with year-to-date issuance surpassing the full-year 2022 total back in July. This growth is built on an expanding middle-market CLO buyer base, as investors take note of higher spreads and CLO tranche subordination on offer.

We expect continued growth from the middle-market CLO space in 2024. Many middle-market CLO issuers have told us that they plan to increase their use of CLOs as a means of diversifying their funding for direct lending in the coming year, and many investors have told us they plan to increase allocations.

Andrew Watt:  S&P Global Ratings has credit estimates on about $400 billion of middle-market debt associated with almost 2,500 companies. Based on credit estimates data, issuers with more than $400 million in debt constituted 26% of borrowers in 2023, compared with 15% in 2020. The growth reflects a combination of factors--including better returns, stable performance of the asset class, and the use of CLOs as a means of diversifying issuer funding sources.

Ramki Muthukrishnan, Head of U.S. Leveraged Finance:  Leveraged loan issuance for 2024 is likely to be driven by refinancing of 'B' and higher rated issuers to address the maturity wall of predominantly 2026 loans. Issuance of 'B-' rated debt may remain more muted as CLO managers seek to de-risk their collateral pools. Otherwise, the trend of lower-rated issuers tapping the private credit markets is likely to continue given the challenging BSL market dynamics.

From a performance standpoint, the steep increase in benchmark rates, ongoing inflation, and growth pressure have strained coverage and earnings, especially for 'B-' and lower rated companies. A quarter of 'B-' issuers and just under half of 'CCC' category issuers have interest coverage ratios of less than one.

To combat the rise in debt servicing costs, many speculative-grade (rated 'BB+' or below) issuers have managed their cash flow through a combination of cost reductions, better working capital management, passing costs to customers, and retraction of capital spending. Even so, more than half of 'B-' issuers and more than one-third of 'B' issuers are generating negative free operating cash flow.

We forecast speculative-grade issuer defaults to reach 5% by September 2024.

Sebnem Caglayan, Analytical Manager for Nonbank Financial Institutions Ratings:  We approach 2024 with stable outlooks on all 11 BDCs we rate, reflecting low leverage, diversified funding mixes, modest strains in asset quality, affiliation with broader asset managers, and adequate liquidity to meet ongoing requirements--but BDCs will face higher-for-longer headwinds. We expect valuations will be more volatile in 2024 because of the choppy macroeconomic environment. We anticipate that the interest coverage ratio for BDCs' underlying portfolio will decline further.

And we expect higher-for-longer interest rates and persistently high inflation will test borrowers in certain sectors that may struggle to pass rising costs to end users, constraining those borrowers' ability to service debt and increasing the probability of default. As we look forward into 2024, select portfolio companies of BDCs will likely struggle with earnings pressure and higher interest costs. We will continue to monitor for nonaccruals, payment-in-kind income, liquidity needs, and changes to unrealized losses--and could take appropriate rating actions as needed.

Writers: Molly Mintz and Joe Maguire