As the Fed cuts rates, what can we expect from private credit?

Private credit has experienced remarkable growth in recent years due to a favourable demand-supply dynamic and the retreat of traditional lenders. Since the Global Financial Crisis, the asset class has grown steadily and now rivals the size of the broadly syndicated loan market with approximately US$1.7 trillion in global assets under management, according to data from Preqin and Pitchbook. 

Its sheer scale today provides evidence of a secular shift towards borrowers being equally accustomed to financing through private credit or the more traditional broadly syndicated loan market.

Now, like other income-oriented assets, the private credit asset class faces a broader regime shift - a potential end to persistently high interest rates. 

With the US Federal Reserve finally embarking on rate cuts, questions on how such an environment would impact private credit as an asset class, especially in terms of its yield, would naturally arise.

While future rate cuts would reduce headline coupon income from the asset class to some degree, we will detail the characteristics of private credit that we believe continue to make the asset class attractive from an income standpoint, and why private credit should continue to be thought of as a valuable complement to one’s public market income portfolio.

Is falling benchmark rates a concern for private credit investors?

Income represents a significant portion of returns from investing into private credit, and generally, the underlying loans given to borrowers would have floating interest rates. 

Direct lending, one of the largest sub-sectors within private credit, is a good example as it typically has floating interest rates tied to a benchmark rate. As benchmark rates fall, the headline coupon income would naturally decline. Spread compression is another concern amidst the competitive landscape between private credit and broadly syndicated loan markets. 

New direct lending loans across more than 70 business development companies (BDCs) have experienced some degree of spread compression over the last 3 quarters, with newly originated loan spreads of at least 600bps above the base rate no longer being the norm, a Pitchbook report shows. 

Another finding was there has been a notable shift in spread distribution, with the largest concentration of spreads now occurring in the 550 to 599bps range, down from 600-649bps two quarters ago.

The chart below shows that concerns about falling all-in yields from direct lending may be overstated, however. While base rates have fallen and some spread compression has taken place, we see that over the longer term, the impact of rate cuts on yield compression has been relatively mild, and private credit has maintained an attractive yield. 

During two major rate-cutting cycles since 2005, one during the Global Financial Crisis (Sep 2007 - Dec 2008) and the other triggered by the COVID crisis (Aug 2019 - Mar 2020), private credit direct lending maintained a consistent and stable income return each year, with only a slight decrease from 10% in 2019 to 9% in 2020.

Over the past 20 years, annual income return from direct lending has remained rangebound, between 9% and 13%, averaging around 10.8% per year. This demonstrates the resilience of the income return from private credit through various market cycles, regardless of rate cuts. Next, we explore why private credit has been able to maintain this attractive level of income over time. 

Reasons for the resilience of private credit income

The high level of income derived from private credit can be attributed to several factors. Firstly, the high degree of flexibility, customisability in the loan structures, and the illiquid nature of the underlying loans allow for a higher spread over the benchmark rate when compared to publicly syndicated loans, therefore providing an overall higher return and income level for the lender and investor.

Additionally, unlike bank-syndicated loans that are actively traded, private direct loans are not subject to syndication risks and are not publicly tradable, allowing them to command an illiquidity yield premium that is not easily eroded.

Furthermore, floating rate loans often include contracted floors on reference rates such as SOFR, providing an additional layer of protection for lenders when rates decline. This helps safeguard income levels and protect lenders and investors from the impact of falling rates. 

Importantly, borrowers turn to the private credit market for the certainty of capital rather than the cost of capital, and for that, they would be willing to pay a premium. 

Because of these fundamental reasons, we anticipate that the yield premium in private credit will remain relatively attractive and stable throughout the market cycle.

More catalysts: Soft landing and lower rates supporting M&A activities

In the past two years or so, high interest rates resulted in weaker valuations and a poor exit environment, leading to a slump in dealmaking. 

A pronounced decline in deal-making activity in the US in 2022 and 2023 is showing signs of improvement

Now with interest rates set to trend lower, we may start to witness a reversal of that. For instance, a lower risk-free rate environment reduces the overall weighted average cost of capital (WACC) for a company, implying a lower rate at which future cash flows are discounted, thus helping improve overall exit valuations. 

Now, as overall discount rates and cost of debt capital fall, financing an acquisition would be relatively less expensive. In other words, rate cuts would in fact encourage and reignite the muted environment for mergers and acquisitions and buyouts, which could be a tailwind for private credit fundraising. An anticipated return of a more normalised M&A environment would catalyse transaction multiples and see valuations start to improve. Subsequently, more target companies which chose to stay “private for longer” would now be more willing and likely to consider an exit. 

Data compiled by BCG shows that private equity activity in the US has made a significant comeback in 2024, with the total deal value up 21% compared to the same period in 2023. Globally, deal value is also higher, growing by 10% year-on-year. A larger pipeline of M&A transactions would likely come to the market, increasing the demand for capital to finance such deals.

With a lower cost of debt capital, we are likely to see a return to a higher reliance on debt capital relative to equity, where sponsors obtain a larger proportion of deal capital from lending as opposed to equity capital. This will further facilitate private credit deal activities. 

Weighing private credit as an asset class

While private credit is still a relatively new asset class, the growth and evolution of the asset class have been significant. Investor participation has climbed as both institutional and retail investors with longer horizons search for higher yields on their capital than achievable through public fixed income. More recently, access to private credit investing has also improved with the rise of private evergreen funds today that offer better liquidity. 

With the large fundraises in private credit and looser lending standards in recent years, particularly during a high rate environment, one concern is the increased risk of non-accruals amongst loans.

The risk of non-accruals is on the rise this year, according to Moody’s Ratings. For instance, Blackrock TCP Capital Corp (TCPC), which lends directly to US middle market companies, saw an increase in non-accruals in its direct lending portfolio from 1.2% to 2.2% in 4Q 2023. 

Data from JP Morgan also shows that direct loans originated in 2021-2022 were underwritten with higher leverage, where Net Debt/EBITDA averaged around 5.5%. Since 2023 however, this average has fallen back below 5% to around 4.5%. These are encouraging signals that underwriting standards and fundamentals have improved, with borrower leverage returning to healthier levels. 

In selecting investments, it is therefore important to assess if there is any concentration in loan vintages - where borrowers likely faced the most pressure, while keeping at the core of one’s investment due diligence process the ability to select top managers with high standards of underwriting and a strong track record.

With its unique advantage in providing a high, steady, and less-correlated source of income relative to public fixed income, private credit remains an important asset class for one’s long-term investment portfolio, where taking some illiquidity risk is not an issue. 

Start with Endowus

Private credit is in a sweet spot to benefit from several tailwinds, and we may well see a meaningful supply of private credit investment opportunities arise in the near term. Endowus offers a gateway to these exclusive opportunities.

Through our platform, you can access best-in-class fund strategies benefiting from our curated selection and commitment to transparent, differentiated, and low-cost investing. 

Log in to your Endowus account to unveil private credit strategies and other leading alternative strategies. For more information on Endowus Private Wealth and hedge fund investing, please contact us for a consultation.