(Editor's Note: In this series of articles, we answer the pressing Questions That Matter on the uncertainties that will shape 2025—collected through our interactions with investors and other market participants. The series is aligned with the key themes we're watching in the coming year and is part of our Global Credit Outlook 2025.)

Recent and upcoming rate cuts will provide relief for private credit borrowers through lower funding costs in 2025, even as many have already benefitted from repricing and improving financing conditions.

How This Will Shape 2025

Repricing will continue to change market dynamics.   Repricings have defined recent broadly syndicated loan (BSL) activity, with spreads narrowing on more than 40% of loans in 2024. To a smaller degree, this is affecting private credit as well, reducing the overall cost of funding for many issuers. New issue 'B' rated leveraged BSL yields have fallen by a full percentage point since the beginning of the year (to 9% in the U.S. and close to 7% in Europe), with their spreads holding below 400 basis points (bps). While potential competition between public and private markets is supporting tight pricing, yields have already started falling as investors take a more constructive view of credit in light of rate cuts and the increased prospect of a soft landing.

Companies should see a bigger benefit from rate cuts in 2025 than this year.   We expect lower rates will take some time to flow through corporate financials, eventually improving borrowers' coverage ratios and free operating cash flows. Where cash flow pressure from higher interest rates increased payment-in-kind (PIK) interest payments, falling rates will eventually ease pressure on liquidity and cash flows. We are already seeing a small dip in instances of collateralized loan obligations (CLO) managers' specified notifications of conversion of cash-paying tranches to PIK. For spreads, we are also seeing a tightening between the yields on broadly syndicated loans and private credit lending.

Competition and convergence between public and private markets will continue.   With growth and innovations in private markets, some borrowers have the luxury of choice between broadly syndicated or private credit. This is leading to competition and tighter pricing. For instance, the spread between private credit loans and BSL is narrowing to less than a percentage point within the portfolios of business development companies (BDCs). While BSL pricing is often lower, transparency marks another fundamental difference. Transparency is embedded in public and BSL markets through systems such as market pricing, data on deals and issuance, or the availability of public ratings. In private markets, transparency varies, with larger managers seeing a greater share of deal flow. Some investors are approaching the private markets with caution, given this asymmetry in information and transparency.

What We Think And Why

As private credit matures, we expect size and sophistication to scale.   As private credit finds its balance with BSLs and high-yield bonds, this offers borrowers more diversification in funding. Private credit is best-positioned to provide execution speed, certainty, and flexibility in terms and structure of payment, such as delayed draws and PIK toggle options, as well as recurring revenue deals with revenue-based leverage covenants. Private credit also meets the needs of lower and traditional middle markets where smaller loans do not offer the scale needed for syndication.

Naturally, there is some overlap in the upper middle market and the syndicated loan market where borrowers have options for private or public credit. We expect some borrowers operating in this zone of overlap will continue to refinance BSLs with private credit (and vice versa) as they seek the best possible terms and pricing. While this competition can improve financing conditions for borrowers, it also brings the potential risk of more aggressive underwriting and looser documentation.

Documentation and covenants will likely continue to ease.   While the lower middle market features financial maintenance covenants, an increasing number of upper-middle-market entities and even some core-middle-market entities are dispensing with these. Possibly, competition with the BSL market is leveling the playing field. We reviewed more than 1,000 credit agreements from loans executed last year and found maintenance covenants were less common among larger deals. Increasingly, private debt borrowers are also shedding financial maintenance covenants through amendments.

One of the stronger points for middle-market loans has been the quality of documentation. Even as other aspects of the terms remain intact, the elimination of maintenance covenants takes away a strong point of negotiation and leverage for lenders in this space. With weaker documentation and fewer covenants, credit quality is of even greater importance.

The cohort of ratings may evolve, and this could affect the asset mix of investor vehicles.   Strong demand for credit and the compression of 'AAA' rated liability spreads improved the economics of lending through investor vehicles, spurring CLO issuance up more than 50% in the U.S. (and more than 80% in Europe) over 2023's volume.

In Europe, the population of 'B-' and 'CCC+' rated issuers has shrunk following several upgrades. Despite this, European CLOs' exposure to the 'B-' and 'CCC+' baskets has increased in the past year, largely due to a few downgrades of widely held issuers such as Altice. In the U.S., by contrast, CLO holdings of 'B-' credit is declining. While managers generally prefer to hold higher-rated credits, the 'B-' cohort has also shrunk as some have refinanced through private credit.

Resounding CLO issuance is also seen among middle-market CLOs. Issuance of these in the U.S. is reaching a new all-time high, and Europe is reportedly preparing for its first middle-market CLO launch. Initial declines in benchmark interest rates in 2024 have led to modest improvements in the credit quality of credit estimated companies (borrowers with loans held by middle-market CLOs). While the impact of lower rates so far has been modest, we expect the improvements will be more pronounced in 2025.

What Could Change

Private equity may find new exit opportunities.   The decline in merger and acquisition activity in 2022 and 2023 has left financial sponsors searching for exit opportunities. Many private-equity funds are approaching or well into their harvest period--the time to exit their investments of portfolio companies to pay back their investors. The average holding period of portfolio companies is the highest it's ever been (based on PitchBook LCD), further pressuring sponsors to look for exit opportunities through sponsor-to-sponsor sales, sales to strategic buyers, IPOs, or secondary funds. To close valuation gaps, sellers and potential buyers are testing new deal features, including delayed payments with a pre-arranged price (such as TPG Capital's and GIC Private Ltd.'s recent acquisition of Techem from Partners Group). We're also seeing an uptick in dividend recaps funded through BSL and private credit as general partners source ways to return capital.

More certainty on rates and valuations could increase mergers and acquisitions and leveraged buyouts, providing more loan paper to a CLO market that's hungry for deals as long as financing and macro conditions remain supportive.

Private markets may tap new sources of liquidity.   Private credit is traditionally an illiquid, buy-and-hold asset, with little secondary-market trading. New structures and vehicles may provide new sources of liquidity, or they may expose risks of the assets' underlying illiquidity. At the holding company level, fund managers have been turning to fund financing options such as net asset value (NAV) loans, subscription lines, and capital call facilities to source more liquidity. Beyond this fund financing, asset managers reportedly have proposed private credit exchange-traded funds (ETFs), some of which include plans for secondary trading desks to provide liquidity. But new structures and market innovations need to be assessed with care, especially when increased complexity is not accompanied by increased transparency.

We expect investors' demand for some type of secondary market will continue to rise with newer parties and larger funds entering the private credit market. For instance, portfolio trading is reportedly gaining traction because such loans may be easier to model and price than individual private credit loans. These loans are often inefficient or difficult to trade because the instrument is too small, too niche, or too little is known about the borrower. Even as markets are finding innovative approaches to trade private credit, many of these individual instruments will likely continue to present challenges to trading.

Convergence may bring new cooperation.   The market continues to evolve with more strategic tie-ups between banks and private credit, as well as between insurance and alternative asset managers. As the Basel III endgame proposal brings clarity to banks' capital reserve requirements, this could lead to derisking balance sheets and moving away from financing risk assets. As banks derisk, alternative asset managers are expanding beyond middle-market and corporate lending, private credit is expanding into asset-based finance, including consumer lending and esoteric assets, along with project finance and infrastructure. While this expansion may offer much larger investment opportunities at higher rates of return, but also with more complexity.

While this could set the stage for increased competition, it also provides opportunities for cooperation. Private credit is gaining capital to deploy, just as the banks and other lenders may be pulling back from some of their traditional areas. While falling yields and improving financing conditions appear to be supporting the growth of this market, transparency, liquidity, and credit quality remain central challenges for investors in this space.

Read More

• Private Credit And Middle-Market CLO Quarterly, Oct. 18, 2024
• Documentation, Flexible Structuring Continue To Reign In Private Credit, Sept. 17, 2024
• BDCs Extend Private Credit Maturities As Financing Eases, Aug. 15, 2024