Pursuit of higher yields, lower volatility and uncorrelated returns has led investors deeper into private markets over the past decade.
Published: April 18, 2023
Inflation, higher interest rates and slowing economies will test both public and private markets, but the latter’s key risk factors — illiquidity and opacity — may leave investors lost at sea.
The spotlight is now firmly on private markets, but their position in the financial markets and their relationship with the public markets is the result of decades of evolution. The maturation and diversification of capital raising in the past 30 years reflect how public and private markets have come to work in tandem to fund businesses in all stages of development — from startup to establishment, and even in distress.
The broadly syndicated loan (BSL) market opened bank-based private lending as an alternative to the public fixed-income and equity markets in the 1990s. As the BSL market grew — first through the tech boom of the 2000s, then through the pre-financial crisis market (which unlocked the European market), and finally through the bull run of the past decade plus — it enabled private equity and private companies to raise increasing amounts of funding for ever-larger buyouts. Excluding their ratings, private companies have been able to remain private while maintaining access to capital markets.
Interdependence between arrangers, borrowers and investors has grown, further fueling private market growth. The bank-dominated investor base diversified to include institutions through the growth of prime rate funds, credit funds and the market for collateralized loan obligations (CLOs).
Private equity has been integral to the growth of institutional money over the past 15 years. Firms have raised a monumental amount of capital, especially since the 2010 Dodd-Frank Act, which accelerated the shift of funding to nonbanks. Private equity growth nourished private markets of all types: private lending, real estate, infrastructure and now a growing investment in energy and natural resources.
The growth in private equity supported the expansion of middle-market businesses through investor funding structures including private credit funds, business development companies (BDCs), middle-market CLOs and now interval funds. When it involves institutional investors, nonbank lending has been brought into the capital fundraising process on near-equal terms to banks. Private equity’s existing role in the BSL market eased this expansion as it had already acted both as a sponsor of large corporates and as an investor through its institutional manager presence.
The challenge now is that as private markets grow, so does their relationship with retail markets, resulting in increased regulatory scrutiny. As the global economy navigates difficult times, there is a significant risk of losses in private markets through defaults and restructurings. Opacity in private markets makes it difficult for institutional investors to assess risks in real time, and it is even more difficult for retail investors.
Over the past decade, private markets have become an integral part of the capital markets. Depending on a borrower’s characteristics — size, strategy, sector, location — private markets can offer a more customized funding option that supports companies in earlier stages of growth. Private market investments tend to be buy-and-hold, meaning they have a long-term investment horizon and a flexible funding structure, and they can support total return strategies and better tolerate business models that are cash flow-negative in the early years.
Private markets have supported the growth of innovative and transformative business models in healthcare and technology. They have enabled the scalability and maturation of niche middle-market business models, such as pet services, heating, ventilation and air-conditioning services or landscapers, through accessible capital funding and consolidation. In the past year, as liquidity dried up in the public markets, they have allowed the credit markets to remain open and functioning. This is largely because, while “private credit” is often described as a clearly defined type of funding, lines between public and private have been blurring for decades. They remain very different markets, especially regarding transparency and liquidity.
Primary and secondary market transparency varies across the “public to private debt” spectrum. Public companies that raise funding through public bond or equity offerings are the most transparent. They must maintain publicly available financial statements, and their secondary markets are highly liquid. This allows managers to actively manage their portfolios amid a consistent flow of information about the ongoing health of public companies.
Private companies that raise funding through BSLs, a form of private debt, are not required to maintain publicly available financial statements, but they need their BSLs to be rated by a nationally recognized statistical rating organization. This rating may be the only publicly available indication of a borrower’s credit health. Most of the BSL market has predictable secondary market liquidity and independent mark-to-market pricing available to provide transparency on the secondary market.
Private credit is at the opposite end of this spectrum. This debt is not traded in a secondary market: Loans are negotiated directly between lender and borrower, and there is little information publicly available on individual borrowers’ credit health.
The growth in private lending was particularly marked over the past decade as investors sought yield and returns. Low interest rates allowed the capital markets to raise debt at historically low rates and encouraged investment in a growing number of investment vehicles geared for both institutional and retail markets. Alternative asset funds — including private equity, private debt, venture capital and real assets — have expanded due to this massive injection of investment capital. Investments made by these funds range from early- to late-stage companies, senior secured debt to equity, and project finance to corporate finance.
But private markets are exactly that — private — and tracking the flow of private equity funding through to investments is akin to navigating a labyrinth in the dark. Visibility is low, and twists and turns are numerous. It is hard to predict where the funding will end up and how much will be allocated.
The boom in private markets, especially in private lending, in the past decade was fueled by low interest rates and strong economic growth. The switch to higher-for-longer rates with elevated inflation and the continued risk of recession raises the specter of defaults for all borrowers — especially private markets. The opacity of private markets and the lack of a secondary market and short-term liquidity may be an issue.
The interplay of public and private lending in today’s credit markets traces back to the evolution of floating-rate bank loans into BSLs. Floating-rate bank loans blossomed in the 1990s following the creation of prime rate funds. These funds grew on the view that they would provide superior returns to money market funds; despite being speculative-grade corporate loans, their senior secured position made them relatively low risk. Prime rate funds were originally in closed-end funds, limiting and controlling redemptions due to their illiquidity, but they eventually became more widespread through open-end funds. Though market conditions were ripe for corporate borrowers, the increasing demand through investor vehicle structures was a key driver of BSL market growth.
Alternative asset managers have created new funds devoted to private debt over the past decade, adding scale in the industry to compete with BSLs. Along with high yield and BSLs, private equity managers have tapped into private credit as a source of debt funding that offers both scale and flexibility. Pitchbook LCD estimates the par value of the institutional BSL market is roughly $1.4 trillion, compared with $1.5 trillion for high-yield bonds, and Preqin estimates the size of private debt assets under management at a comparable $1.3 trillion. These three sources of funding underpin the leveraged finance market.
Over the past decade, private markets have grown substantially. The Dodd-Frank Act spurred the initial transition from banks, and then the low interest rate environment nurtured growth. For companies, becoming, or staying, private was more appealing after the Sarbanes-Oxley Act lifted the financial reporting requirements — and expense — for public companies in 2002. Startups have since opted to stay private for longer, and private equity managers have found no shortage of companies willing to go from public to private.
While private debt was an established source of funding for the middle market, it gained further traction among lenders, investors and borrowers after the global financial crisis. For lenders, the Dodd-Frank Act stiffened the capital charges to banks for underwriting loans to riskier companies. Banks pulled back from lending to small to middle-market companies, creating opportunities for nonbank lenders to fill the gap. Between 2010 and 2022, the AUM of private equity and private debt funds grew by about 4.3x each, to $7.6 trillion and $1.3 trillion, respectively [see chart]. Much of this growth took place after 2019.
For investors, higher yields and the perceived lower volatility of private assets — a direct result of illiquidity and the lack of secondary market pricing — proved appealing. For borrowers, the ease and certainty of execution of funding from direct lenders made private credit an attractive alternative to the BSL market. During times of dislocation and uncertainty, when financing was challenged in the broadly syndicated and bond markets, private debt dry powder remained a source of capital that could be quickly deployed to support deals.
Investors increased their alternative asset allocations and, flush with dry powder, global private equity- and venture capital-backed M&A transactions surged to a decade-long high in 2021, with over $600 billion in volume from more than 3,700 deals. Private equity and private debt are particularly intertwined. Private equity firms typically evaluate financing options for their sponsored companies from the high-yield, broadly syndicated private credit market, where the debt resides on the sponsored company’s balance sheet. Over the past 10 years, we have seen a convergence between the broadly syndicated and direct-lending markets as sponsors and borrowers increasingly consider both when they evaluate funding sources.
As the private debt market has grown, small groups of lenders (clubs) have been able to extend larger loans – including multi-billion dollar financing packages.
Deal volume pulled back by 35% in 2022 to about $400 billion. Even with this sharp retreat, M&A volume remained elevated, at its second-highest level since 2012. As investors tried to find their footing in uncertain market conditions in 2022, deal financing grew more difficult. Private equity firms now face longer hold times and fewer exit routes. Volatile markets have dampened lucrative IPO exits, while challenging financing conditions have made secondary buyouts more difficult. While these exit paths may be limited, some specialist firms are finding success with consolidations, such as in the tech sector. However, longer hold times will potentially drag down new private equity fundraising.
Growth in the private markets over the past decade coincided with a period of exceedingly low interest rates. Low financing costs made more private equity take-private deals viable, and borrowers could more easily meet interest expenses when their cost of debt was low. With benchmark rates such as the London interbank offered rate, its replacement the secured overnight financing rate and the Federal Funds Rate pushing 5%, leveraged borrowers could face a reckoning about their ability to service their debt. This will test managers and their investments as well as the private market framework that guides investors in troubled times.
For private equity and private debt funds, rough seas will lead to divergences in the performance of funds by vintage or by manager. Vintages that deployed large amounts of capital just before the sharp increase in rates appear to be on a shakier footing than those that invested when rates were higher and multiples were lower.
On the funding side, just as borrowers were growing accustomed to having more funding options on offer from high-yield bonds, BSLs and private credit, investors’ pullback from risky assets in 2022 limited financing options for many weaker borrowers. For some, private credit may have been the only remaining source of funding. And the cost of that funding was on the rise.
Higher rates have already added new sources of competition to the private market. Investors may not be so willing to search for yield in the private markets if they can find more liquid and lower credit risk assets that offer an acceptable yield.
The days of midmarket loans automatically being marked at par are over. This is no longer acceptable to limited partners or auditors as principal-based guidelines from the International Private Equity and Venture Capital Valuation and the American Institute of Certified Public Accountants have been updated, and there have been material changes to accounting standards, i.e., due to IFRS 9. Investors at all levels want to know what their investments, and the underlying collateral, are worth in both the short and long term. But within current guidelines, private market asset prices may be stickier than those of their publicly traded counterparts.
Mark-to-market valuations of public equity are done in real time, based upon trade data. The valuation of bonds is based on real-time trade data too, while that of BSLs is often based on indicative bids from traders. The fair value for private credit reflects the lack of a secondary market.
Under the principal-based approach, private asset managers have some discretion in how they tackle valuation or the valuation services they use. Valuations for performing deals involve determining an appropriate discount rate for the riskiness of the cash flows the loan is projected to produce, along with adjustments for illiquidity premiums, duration basis, credit quality basis and different levels of covenants. For nonperforming deals, the net recovery approach can also be used to estimate fair value. The net recovery approach is applied by performing a waterfall propriety analysis.
Although public equity and bonds experienced steep declines in 2022, private market returns were more stable. While the S&P 500 index retreated in each of the first three quarters of 2022, declining by 24%, the Preqin private equity index declined by just 3% in the same period. Returns for private credit funds, many of which invest in middle-market companies’ senior secured debt, were flat because a gain in the first quarter of 2022 was offset by a decline in the third quarter of that year. Total returns for real asset funds, which target investments with steady cash flows that are backed by tangible assets, were positive in each quarter.
Divergences between public and private market asset pricing can lead to a rift between markets. For example, Blackstone’s real estate-focused BREIT fund restricted investor withdrawals after monthly and quarterly withdrawal limits were reached. These withdrawals gained steam as other public real estate funds showed steeper losses than BREIT.
Private markets have become increasingly integral to financial markets and the real economy, as evidenced by the breadth of private equity-sponsored companies and their prevalence among speculative-grade-rated companies. The versatility and certainty of private credit has transformed it into a competitive source of funding for the leveraged finance market. The sea change of higher-for-longer interest rates poses a new test that separates winners from losers.
As water always finds its level, private markets will too. There will be losses, but the participants are seasoned, experienced parties, and private markets are now an embedded part of the capital-raising process. They support startup firms through custom funding solutions, longer-term commitments and closer relationships, and they can also take on the role of banks in larger corporate funding due to their liquidity and sophistication. Although rising rates may expose hazards in both private and public credit markets, we expect private markets are here to stay. They are likely to remain an integral source of funding for the future, meeting the needs of new and innovative growth models, such as cleantech and healthcare, as well as those of traditional large corporate M&A.
This article was authored by a cross-section of representatives from S&P Global and in certain circumstances external guest authors. The views expressed are those of the authors and do not necessarily reflect the views or positions of any entities they represent and are not necessarily reflected in the products and services those entities offer. This research is a publication of S&P Global and does not comment on current or future credit ratings or credit rating methodologies.
