RETURNS for private debt funds have beaten those of private equity (PE) for a second straight quarter, with higher interest rates juicing returns for direct lenders just as buyout funds are hit by an M&A drought.
Private debt funds returned 1.8 per cent in the third quarter of 2023, the latest data available, while buyout funds delivered just 0.35 per cent, according to the State Street Private Equity Index.
Historically, investors have expected bigger returns from PE – with quarterly returns occasionally as high as 12 per cent in State Street’s data – because of its riskier nature. But the status quo has been upended by high rates – a boon for private credit funds, which mostly offer floating rate debt and can still get cash through regular interest payments.
“Higher cashflows from private debt funds makes sense right now,” said Jeff Boswell, head of alternative credit at asset manager Ninety One. “Distributions from PE have dropped because there’s just less deal activity and in private debt you still get that constant coupon.” Still, he does not think this reflects the long-term performance of private equity.
PE funds have fared less well under high rates. Portfolios have suffered because of higher debt-servicing costs and a tough macroeconomic climate. Funds have been reluctant to sell assets and crystallise a paper loss even though exiting businesses is the main way private equity can return cash to investors.
The industry’s other efforts to hand back capital, via NAV (net asset value) financing, continuation vehicles and other methods, have failed to satisfy investors completely. Some are even asking for their money back in exchange for commitments to a new fund.
The data marks the second consecutive quarter that the fast-growing US$1.7-trillion private credit industry has beaten buyout fund returns. It continues the first multi-quarter streak in which private debt has outperformed since the global financial crisis, according to Nan Zhang, head of product implementation and alternative investment research at State Street.
“We are extremely popular right now,” said Bill Sacher, head of private credit at Adams Street Partners. “First lien, senior secured instruments making equity-like returns is a very unusual combination in markets and is especially exciting if you have a bearish view,” he said, referring to typically safer types of debt in the capital structure.
Not so fast
Still, many market participants are generally positive on the long-term health of the private equity industry, and see the outperformance of direct lending strategies as temporary.
That is illustrated by the strength of PE fundraising from third parties compared with private debt funds, with PitchBook data showing that PE had 5.5 per cent growth in capital raised in the first three quarters of 2023, compared with the same period the prior year. Private credit funds saw just 0.8 per cent growth.
For PE returns to come back meaningfully, M&A and IPO markets need to improve. Some say it is only a matter of time before private equity firms begin dealmaking again, as the need to return capital becomes more urgent and as valuation expectations between buyers and sellers narrow. Still, a rebound relies on more clarity on central-bank rate cuts, while the year ahead carries risks including geopolitical flashpoints and multiple elections that could affect risk appetite.
“There will be many periods where private equity will outperform private credit because you’re taking more risk,” said Andrew Bellis, head of private debt at Switzerland-based Partners Group, which has US$76 billion and US$29 billion in assets under management in private equity and private credit, respectively. “There will be times where private credit outperforms, but only until there’s a reversal and over the long-term, PE will outperform.” BLOOMBERG
