Private debt misconceptions

Introduction

Although private debt first emerged as an asset class in the 1990s, it did not gain momentum until after the Global Financial Crisis (GFC) at which point it began capturing market share from traditional banks and public markets. Initially regarded as a return enhancer for fixed-income portfolios in low interest rate environments, private debt has since evolved into a core component of institutional portfolios.

However, as more capital flows into private debt, some worry that its growing popularity might be masking risks that could destabilize the broader economy. These concerns largely stem from the perceived opacity associated with private markets. While that is true, private debt has become more transparent: Business development companies (BDCs) and interval funds now offer regular reporting on holdings and performance.

The rise of private debt is the result of an organic growth fueled by private lenders capitalizing on favorable market conditions. Unlike traditional banks, which have historically been the primary financing sources for middle-market companies, private debt funds are generally less vulnerable to market fluctuations. As a result, they do not pose the same level of systemic risk to the economy.

In this white paper, we explore five misconceptions often brought up when discussing private debt’s rise. By doing so, we highlight private debt’s potential as a valuable addition to traditional portfolios and the broader economy.

Misconception 1: Private debt grew too much too quickly

Which factors led to the private debt market growth? 

Bank disintermediation

Among other things, the GFC revealed deficiencies in the established Basel regulations. In particular, it exposed their inability to prevent banks from amassing excessive leverage as well as insufficient liquidity buffers.

In response, Basel III imposed more stringent capital requirements, which necessitated higher capital reserves
for “riskier” loans such as private loans. It also established new liquidity ratios to ensure banks could withstand liquidity stress. This prompted banks to reorganize their balance sheets toward less risky and more liquid assets to avoid higher capital charges. Finally, Basel III implemented a leverage ratio to curb excessive leverage in the banking sector. These changes collectively limited banks’ capacity to extend loans as freely as they once had.

Ultimately, the new Basel Framework made banks more financially stable. But the retrenchment in private lending left a void, which private debt managers happily filled.

Private equity growth

The expansion of private debt markets over recent years also correlates with the growth of private equity (PE) sponsors, which use borrowed funds to acquire companies. The low interest rates that followed the GFC plus the boom in private lending made debt-financed acquisitions more attractive and led to a surge in leveraged buyouts (LBOs).

The growth of private debt, in this context, can be interpreted as a simple narrative of supply and demand demonstrated by the increase in private debt dry powder as private equity grew (Figure 1).

• PE sponsors sought additional sources of capital to finance their expanding activities—especially in a market where timely and flexible financing options were prized.
• Private lenders emerged as vital players, offering the required capital with more flexible and tailored terms compared with traditional bank lending.

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