Analysis: Private debt markets face reality check as companies grapple with rising rates, recession

Investors were lured by the promise of easy cash from central banks to get private credit. They were attracted to the attractive returns in the low-single and low-double digits. In the wake of the global financial crises, banks had to reduce their lending to corporations -- especially those that were more risky. The private debt market, which is the fastest growing credit sector segment since the financial crisis, is about to experience a speed bump due to investor appetite for risky assets being tested by aggressive monetary tightening. According to Prequin data, the private debt market has risen to $1.4 trillion from $250 billion in 2010. Large positions are held by funds such as Ares, Blackstone, and KKR. Friedman said that private lenders are still deciding how to respond if the downturn is more prolonged than "six month and I'm done with it". With the risk of long-term earnings declines and higher defaults, the jury is still out. The European Central Bank has been tightening at an unprecedented pace, while major central banks have increased rates at breakneck speed. WARNING SIGNS Central banks are removing trillions of dollars worth of extra cash that they have pumped into the economy in the past decade. Warning signs are already flashing such as an increase in redemption requests for an unlisted Blackstone real property income trust. Investors are being more cautious about taking on private debt that is subject to corporate default. The third quarter saw dollar-denominated transactions, which was the first significant increase in 18 months. Based on data from S&P Rating, this is comparable to the 1.6% default rate in public debt markets for speculative grade corporates in the United States. Peter J. Antoszyk (Co-Head, Private Credit Restructuring Group, law firm Proskauer) stated that the default rate for private credit deals was extremely low in the last 18 months. It's not surprising to see it rising, especially when the market is under pressure. According to S&P Global Ratings, private creditors and equity owners helped keep defaults to a minimum after the COVID-19 pandemic. The severity of any recession will determine whether this happens in the next year. PROS and CONS: The market's private, mostly bilateral nature could be a saving grace. Yannick Le Serviget is the Global Head of Leveraged Loans & Private Debt at AXA IM Alts. He said that one benefit of having a small number of lenders to deal with, rather than a large group of creditors, makes it easier for companies to extend maturities and to survive a downturn. Le Serviget stated that shareholders must be able to invest additional funds in the business if they require cash. Many debt funds are considering strategies like bringing in restructuring experts and legal professionals to address potential problems in companies within their portfolio. Friedman stated that there will be "very interesting prospects for" rescue financing and opportunistic loans. Friedman explained that if you can see the problem 12 months in advance, you can finance it. Reporting by Chiara Elsei. Editing by Karin Strohecker, Dhara Ranasinghe and Jane Merriman.