The private debt market, itself the result of global financial upheaval, potentially faces its biggest test yet amid 2023's uncertain economic outlook.

After nearly a decade of rapid growth, private debt could be in for a rude awakening as higher interest rates threaten companies' abilities to service their borrowing costs—which in turn will force investors to think twice about their private debt exposure. Meanwhile, aggressive monetary tightening and the very real prospect of a global recession could also stifle the deal pipeline for alternative lenders, much as it has for private equity firms.

Yet, investors are raising large amounts of capital for the strategy. Earlier this month, Muzinich & Co. said it has hit an €800 million (around $870 million) close on its pan-European debt fund, which has already made 18 investments. Other big-name PE firms also remain bullish on their private credit strategies. In December, KKR was urging its limited partners to increase their allocation to private debt, and Blackstone's credit arm has more than doubled its AUM over the past five years.

The hope is that investors that are adequately diversified, and sufficiently disciplined, will be better placed to navigate their private debt ambitions through stormy seas.

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While the private debt industry predates the global financial crisis, the asset class we know today burst onto the scene as post-2008 regulation forced banks to retrench from the lending market. That has opened the way for alternative lenders—read: private debt—to fill the gap.

As the opportunity for deals expanded, more investors sought exposure. PitchBook's H1 2022 Global Private Debt report shows that, in 2021, private debt managers had around $161.9 billion in dry powder. In the first half of 2022, that figure was at $168.7 billion.

The current global downturn is unlikely to play out like the financial crisis did more than a decade ago. Although private debt is still seen as an alternative form of credit, it's no longer a niche strategy but a large and established industry. With less low-hanging fruit, a slowdown is inevitable.

Fund performance may have already peaked. The most up-to-date PitchBook data shows that median fund performance rose steadily for every vintage year until 2018, when it dropped to 8.73%. The following year, the median topped out at 11.49% before dropping again to 10.97% for the 2020 vintage.

There is no comprehensive, global picture of private debt dealmaking, but a recent Deloitte report covering European transactions revealed a 15.7% year-over-year drop in Q3 2022, with 193 deals completed, down from 229 in the same period a year ago.

PitchBook's data also showed that global debt-focused fundraising has started to slow down. Halfway through 2022, 66 private-debt funds had raised $82 billion, compared with around $93 billion gathered across 130 funds during H1 2021.

Rising interest rates are expected to have both negative and positive consequences for lenders of private debt.

On one hand, some companies will find it harder to source capital from the public markets, prompting many to turn to alternatives. Moreover, as the supply shrinks for funding from traditional sources, private debt funds may be better positioned to negotiate more favorable terms with borrowers.

On the flip side, rising interest rates also are likely to make it more difficult for borrowers already in the private debt portfolio to service their debt and meet their financial obligations. The extent of the strain they feel will depend on how long current market conditions last.

Some areas of the debt market will be affected more than others. Default rates in the high-yield and leveraged-loan markets are expected to rise globally, according to Fitch Ratings. Institutional leveraged loans are estimated to see default rates as high as 3% and 4.5% in the US and Europe, respectively, compared with 0.6% and 2% in 2021.

In comparison, the Proskauer Q3 Private Credit Default Index—which tracks senior-secured and unitranche loans—reported a default rate of 1.56%, an increase from 1.18% in the previous quarter and the first significant increase in 18 months.

The picture isn't all bleak for managers of private debt. Current market conditions will favor opportunistic strategies including distressed securities. In November, Bloomberg reported that The Carlyle Group has plans to raise an $8.5 billion fund to target both distressed debt and special situations.

At the same time, with the private debt market entering uncharted waters, investors are going to be expected to be more disciplined and careful in their selection. The watchword may well be to focus like a laser on strategies that are best positioned to weather the storm.

Featured image by Drew Sanders/PitchBook News

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