The Blog

Musings on corporate finance, fund raising, capital markets and other matters

Changing Dynamics of Private Debt

The Role of Banks: 

Amidst the recent surge in interest rates, banks confront a seemingly contradictory landscape characterised by both a reduction in borrower demand and tightening of lending criteria, but also vastly increased profits in their lending activities. 

2023 saw the highest increase in the UK base rates since 1989, a trend repeated in many other regions. As such forecasts project a notable 4% contraction (£18.8bn decrease) in bank-to-business lending, reflecting diminished borrowing demand exacerbated by higher costs of debt servicing, reduced earnings, and ongoing global supply chain disruptions. More than 70% of corporate bank loans as of H1 2023 were on variable rates, exposing companies to the impact of rising interest rates. At the beginning of 2023, the EY ITEM Club forecasted a .8% rise in write-off rates on business loans and a 3.8% decrease in business-to-bank lending (one of the steepest falls in a decade) for the year. Throughout 2023, banks have responded in turn by tightening lending criteria and at times even selling loan portfolios.  

Notwithstanding, banks have also benefitted generously from high interest rates, making more profit than they have in a long time. Net interest income, profit that banks earn on loans, mortgages, and other interest-bearing assets, reflecting a spread between their funding or borrowing costs and the interest they earn. It's a key measure of profitability and it's closely watched by analysts to assess banks' core lending activity. For example, JPMorgan Chase closed 2023 with $90 billion representing a $37 million increase from 2022.2 Given most agree that interest rates are at their peak, returns will normalize as net interest income will reduce but loan demand will grow, due to decreasing rates. 

The Role of Private Debt Funds: 

Private debt lenders, who can offer more flexible solutions and are often backed by closed-ended funds (and are therefore less sensitive to interest rate variations), have stepped in to fill the gap from banks’ tightened lending criteria and constrained risk appetite.  

As a result, the private debt landscape has been marked by early signs of recovery after a difficult period and increasing of investor confidence. Though higher interest rates and general macroeconomic uncertainty keep the environment below pre-pandemic levels, there were 138 private debt deals completed in Europe in Q3 2023, representing a 24.3% increase from the previous quarter — a noteworthy trend considering the traditional slowdown during the European holiday season. 

Not all private debt is the same and it is useful to note that lending activity in this space correlates closely with M&A activity, as most deals are focused on acquisitions by private equity, which has been severely depressed in 2023. Hence, the broader downtrend in the market (Q3 223 was 23.3% lower compared to Q3 2022) is primarily driven by this link, and such downtrend is much less pronounced outside of the private equity deal space.  

The challenging year has led to a decline in capital raising for private debt funds, with the slowest pace since 2018 and fundraising times averaging 26 months, up from the long-term average of 16 months. Furthermore, private debt managers, face increased scrutiny, are either struggling to raise funds or adopting a more selective approach, impacting deal closures and elongating diligence periods.  

With regards to regional variations, it is notable to observe the dwindling dominance of the UK which has historically led with number of deal closes. From 36% in H2 2022 and a longer-term average of 34% share of total deals in private debt, the UK fell to just over 20% in the first half of 2023. Notably, France led with 74 deals closed, followed by the UK with 68, Germany at 29, and the rest of Europe at 85. 

These numbers may continue to move in same direction given the UK’s deal volume share has decreased whereas France matched 2022’s performance and Germany experienced a 78% surge. Though the Benelux region is still a smaller piece of the pie, it also remained stable, bucking the reduced deal flow observed in the UK.

These dynamics signify a transformative period in the private debt landscape, reshaping the geographical distribution of deals and altering the UK's historical stronghold. 

Public Bond Markets:  

The bond market signals that interest rates will continue to persist well above pre-pandemic levels. As of Q4 2023 there was an average of 4% short-term interest rates compared to the last decade's 1.2% and yields on US ten-year government bonds reaching 4.2%.

There does however seem to be cautious optimism in primary loan markets, evident in the European Leveraged Loan Index rising by 96 points. This resurgence suggests that primary loan markets may increasingly pose competition to private markets, adding complexity to the evolving financial landscape.