Overview
Over the past several years, private debt has become an accepted and major source of capital. Invested capital in private debt has grown from $1.0 trillion in 2020 to $1.4 trillion as of 2024 and is expected to grow to $2.5 trillion by 2028¹. Given the growth, it is worthwhile to examine the underlying drivers and whether the source is sound and sustainable.
Growth Drivers
The reality is that private capital, and its subset, private debt, have existed for decades. Historically, insurance companies have been major providers and remain probably “The” major source of capital. The appeal has been that insurance firms have been willing to forgo liquidity in exchange for additional yield and the ability to craft covenants that provide better protection than those typically afforded in the public markets.
Figure I: Private Capital Ownership Among Annuities
Tech Change
While these conditions have been evident for decades, a more recent development has occurred in the banking industry, which has historically been the major provider of capital to private and many public firms. As is often the case, technology has rendered the old business model banks used to fund their transactions into wreckage. The new tech arrived in the form of innocuous "apps" that allowed customers to easily move funds around without the time-consuming task of visiting a bank. Over the past 18 months, both consumers and, perhaps more importantly, regulators have witnessed banks basically becoming insolvent in a matter of days as deposits flew out the door and illiquid assets remained.
Regulatory Response
The upshot was predictable: regulators insisted on banks both holding more capital and shortening the duration of assets. Hence, corporations were forced to seek alternatives, with the most logical option being private debt providers.
Risk Evaluation
On the risk side, typically, with the rapid growth of a market, the natural concern is that some latent risks will shortly be manifested. In our opinion, there are two ways to evaluate this risk. One is whether the overall indebtedness of borrowers has increased, thereby suggesting that private debt sources are willing to accept riskier transactions, making the entire market more vulnerable. On this score, there is little support that the overall indebtedness (as measured by interest coverage) has generally improved (See the chart below)²
Figure II: Historical Aggregate Interest Coverage Ratio of U.S. Nonfinancial Firms
Another measure is the trend in defaults, which again is an indicator of new capital being willing to accept riskier transactions, thereby increasing the risk to the overall market. Again, there is little support for this type of development, as evidenced by the chart below from Bank of America.³
Figure III: Aggregate US Corporate Default Rate
However, there is another point generally missed by market observers. With private debt, the public does not have the same exposure that generally exists with banks. For banks, the federal government, via the FDIC, has significant exposure, as do a plethora of depositors through their various accounts. In the case of private debt, there is typically match-funding of obligations, and in the case of default, losses are typically borne solely by the investor.
Looking Forward
We doubt that banks will materially alter their manner of doing business as consumers demand the convenience of quick cash transfers and are unwilling to accept money market rates on deposits. However, the ubiquity of banks and their deep relationships with various corporations ensure that much of the lending will still be done via traditional banks. Another point worth exploring is whether we are indeed in a “Goldilocks” period for most fixed income investors. There is no doubt that this is an important topic, but it will have to wait for another installment.
Sources
[1] https://www.morganstanley.com/ideas/private-credit-outlook-considerations
[2] htps://www.federalreserve.gov/econres/notes/feds-notes/stress-testing-the-corporate-debt-servicing-capacity-a-scenario-analysis-20240509.html
[3] Bank of America Global Research, as of 6/18/2024
[Picture I] The Silicon Valley Bank Catastrophe | The New Yorker
[Figure I] McKinsey & Company Global Insurance Report 2023