The direct lending market’s resilience “will be tested moving forward” as more losses materialise over the coming years, new research has warned.
A report from Allianz noted the phenomenal growth of the private debt market, which has grown by 60 per cent to $1.6tn in the last five years.
Allianz anticipates annual 15 per cent growth in assets under management going forward but said that “some defaults in pro-cyclical sectors are likely”.
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It expects direct lending to continue to dominate the private credit sector but noted that there could be challenges ahead.
“As a relatively new asset class, private credit will face significant stress, particularly as managers dependent on cyclical sectors grapple with elevated financing rates and sluggish earnings growth,” the report said. “Losses are expected to materialize gradually over several years, highlighting potential performance disparities among sectors and fund managers.”
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However, Allianz added that “more defensively structured fund vintages” are forecast to outperform older ones throughout the economic cycle, as these funds tend to focus on “market mega-trends” that should outperform other sectors and markets.
The report said that higher borrowing costs could heighten financial risks, potentially exacerbating defaults. It said that this could lead to underperformance relative to public markets if rates are kept high for longer.
However, it highlighted that private credit’s ability to influence deal structures and enforce strict covenants could sustain lower default rates and higher recover rates than public market counterparts.
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“We maintain that the private credit sector, and direct lending in particular, will sustain its role in the portfolios of retail and institutional investors, offering potentially higher returns than their publicly traded peers,” Allianz said.
“However, it’s important to acknowledge that these elevated returns come with risks. Specifically, the promise of future gains could be jeopardized during a market downturn, particularly if triggered by stringent monetary policies. This scenario may result in liquidity challenges due to the scant secondary market for private debt. Additionally, significant mark-to-market adjustments may occur at the asset’s maturity or in the event of a default.”
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