Private debt must become more transparent
2021 was a record year for private debt in Europe. The private equity market was buzzing and constantly produced highly valued M&A deals, which the debt funds were able to finance with high leverage. The turnaround in interest rates in 2022 played into the debt funds' hands. The variable interest component via Euribor meant that the higher interest rates had a direct impact – easy money for the debt funds.
However, debt funds could feel the downside in the future. Although the turnaround in interest rates has not completely stifled the M&A market, it has certainly caused it to shrink. The number of new private equity deals has fallen noticeably. If transactions took place they were significantly smaller and add-ons for existing portfolio companies, which financial investors also found more difficult or impossible to sell.
Debt funds feed almost exclusively on existing business
Debt funds have so far been able to make a virtue of this problem by refinancing the expiring LBO financings of private equity investors or by replacing banks that were unable or unwilling to participate in further add-on acquisitions. According to the latest Mid Cap Monitor from Houlihan Lokey, 61% of all financing in Germany last year was from existing companies. At 49%, the proportion of new business (primaries and secondaries) was the lowest it has ever been since the data series was first compiled.
Nevertheless, the turnaround in interest rates could still become a problem for private debt. Namely when the refinancing of M&A deals from the boom year 2021 is due. With a typical term of seven years, the issue is therefore likely to become more explosive from next year.
According to data from Deloitte, a total of 790 transactions were financed by debt funds in Europe in 2021. These were concluded at the old conditions – i.e. before the interest rate turnaround – and are therefore likely to have been financed quite aggressively in some cases, especially as the Euribor is unlikely to have played a major role in the plans at the time.
When is a loan "defaulted"?
Usually, leverage is reduced over the term because part of the private equity business model is to take over a company with the help of high debt, which is then gradually reduced from the cash flow. This reduces the refinancing risk. In addition, interest rates have probably peaked and are likely to fall until refinancing. For the deals that were financed particularly aggressively at the time, however, this could still be a hot potato.
This raises the question of how the default rates of private debt will develop. The problem here is that, as these are private markets, the public has little or no insight into the actual credit quality of the debt funds. Moody's also criticised this recently. The rating agency predicts similar default rates for the direct lending sector as for the broad syndication markets – i.e. 3% or more over the next twelve months.
Debt funds think more flexibly about defaults
If you talk to fund managers, they themselves talk about lower values. This is probably because they define "default" differently. For example, if a borrower is unable to pay their interest on time and instead pushes it to the end of the term – in the hope that it will then be paid – then Moody's considers this to be a default. Debt funds see it differently.
If a company under stress receives a straightforward deferral from its lender away from the public eye in order to solve the underlying problem, this is good for everyone involved – provided the bet works out. If it doesn't, the real loan default comes out of nowhere for outsiders. The more private debt wants to open up to private investors in fundraising, the more transparent the sector must become. It can then no longer manage its risks in secret!
The increased investor appetite for distressed and special situation funds shows that the risks are being recognised in the market. According to a survey by data provider Preqin, investors are currently showing greater interest in these riskier investment strategies within the private debt universe.
