Private debt appears to be hitting its stride. Higher interest rates and spreads coupled with a pullback in banking activity are helping private debt become more ‘mainstream’ and less ‘alternative’ even in larger deals traditionally financed by banks. Recently, many private equity players have taken the plunge by raising large private debt funds and financing debt in their own private equity deals. In this report, we intend to delve into the factors behind these trends both in Canada and around the world.
As the global private debt market continues to grow, it is important to examine the unique dynamics influencing private debt investing and allocation trends within the Canadian market. Despite numerous tailwinds in the sector, Canadian investment in alternatives, including private debt, continues to significantly lag the broader global market.
The current inflation-induced, high-interest- rate environment has created a liquidity crunch in the highly regulated Canadian credit market. Even though data around Canadian private debt activity is scarce, we have observed that Canadian private debt funds are enjoying healthy pipelines of loan deals, including borrowers traditionally financed by banks. The lack of a Canadian secondaries market across loan types (senior secured, mezzanine and junior) creates a unique opportunity for private debt incumbents in this country.
The most sophisticated investors in the country have been steadily increasing their allocations
to private debt on behalf of Canadians. CPP Investment Board, the country’s largest pension
fund, for example, had $44.4 billion invested in private debt as of Dec. 31, 2022, a 25% increase
since the end of its fiscal year 2021, and a more than 770% increase since 2011.1
Globally, it is estimated that over 30% of investors hold alternative assets in their portfolios.2 In Canada, that number is significantly lower. The Alternative Investment Management Association estimates that the average Canadian wealth advisor has an allocation to alternatives of just 4%, of which private debt is only a subset.3 While private debt funds have lesser transparency
and liquidity relative to public funds, some Canadian investment in alternatives continues to significantly lag the broader global market of the factors behind the abovementioned disparity are that Canadian investment dealers tend to rate alternatives as higher risk without regard to a fund’s historical risk-adjusted return.4 In addition, a regulator-endorsed KYP (“Know Your Product”) requirement limits the practical number of investment products Canadian dealers are willing to sell. The unintended consequence is that, arguably, Canadian investors often have less diversified portfolios relative to the rest of the high-net-worth world.5
The Canadian credit market differs from the U.S. market both in size and the overall structure. As a smaller market, Canada has not been materially affected by recent headwinds in the U.S. banking sector. This is largely due to the difference in the depth of the banking sector between the two markets. The Canadian credit market is largely funded by loans distributed by the five largest banks versus a highly competitive and fragmented banking market in U.S., where regional banks have a large share of the small- and medium-size business loan market.6 There is also an absence of an established secondaries market in Canada unlike in the U.S., where regional banks and Savings & Loans institutions can execute secondary deals and take the exposure off larger banks’ balance sheets. This gap is filled by the private debt industry in Canada.
Many Canadian retail investors have remained on the sidelines due to ongoing legacy issues arising from the collapse of a large Canadian private debt fund that was put into receivership due to fraud. The confusion this has created in the market has had a negative impact on more-established, long-tenured private lenders in Canada, despite their established histories of delivering steady, risk-adjusted returns. With highly liquid instruments like High-Interest Savings Accounts or GICs offering ~5% annual returns, some retail investors have also opted to park their capital in these sorts of investments while pulling out from both private and public markets. In our view, such allocations work against the principle of portfolio diversification, as cash and GICs are essentially fixed income vehicles.
While the recent banking crisis has had a ripple effect across countless industries, the timing of it could not have been better for the established global private debt industry, which remains well-positioned to continue to thrive with large stockpiles of cash chasing good deals.
There are five key dynamics that are setting the stage for the continued growth of the private debt asset class across the globe:
Private debt is increasingly winning market share from the syndicated loan market. In 2022, there were roughly five times more deals financed through private debt versus broadly syndicated loans, compared to an average of 1.7 times in the previous three years (Figure 1).
Source: Leveraged Commentary & Data (LCD)
The near double-digit yields produced by private debt funds in recent years7 have helped create a significant build-up of dry powder (Figure 2). Most recent studies have shown an increased interest in allocating to private debt, even from more conservative family office investors with investment objectives that include capital preservation and portfolio income (Figure 3).
Private credit has remained a reliable funding source for middle market deals for years. It was, however, never looked upon as a capital provider for large billion-dollar deals. This changed recently with some large LBOs being entirely financed by private debt. Due to these large deal sizes, private debt funds have started forming syndications with other private direct lenders to finance the whole deal, in turn helping individual lenders diversify concentration risk and enabling them to do more deals across sectors.
As private equity sponsors increasingly seek out private debt financing – over bank loans – to fund the largest transactions, an increasing majority of deals announced are done via private debt loans. As an example of the emergence of this trend, Figure 4 shows all private equity-led take-private deals above US$100 million announced in the U.S. since July 2022. The overwhelming majority of these deals were financed by private debt loans.
Source: Preqin 2022
Source: Ocorian 2022
In a tight-liquidity environment, increased demand for financing has ensured that private debt players have a greater ability to command better deal terms, including lower leverage ratios (Debt/EBITDA) and better debt coverage metrics (loan security). Average leverage multiples have come down and formerly popular covenant-light structures are off the table (Figure 5). Consequently, private debt deals now enjoy higher equity cushions in private equity-led deals.
With high levels of leveraged debt and high yield bonds maturing in the next 4-5 years (Figure 6) – in the face of more limited refinancing possibilities – combined with the fact that banks remain busy clearing the deal backlog from the last couple of years, we believe there is a unique opportunity for private debt to step in and fill the financing gap.
Source: S&P/LCD and BofA Global Research as of 12/31/21. The loan market is represented by the S&P/LSTA Leveraged Loan index, the high yield bond market is represented by BofA/ML High Yield Corporate index. Default rates are by par amount. Investors cannot invest directly in an index.
Although some Canadian investors are currently standing on the sidelines as it relates to private debt, overall favorable dynamics in both the U.S. and Canada, against the backdrop of a U.S. banking crisis, are translating into bullish tailwinds for the private debt industry. The movement of good quality borrowers from a bank’s loan book to senior secured assets of private debt players is highly attractive from a risk-return standpoint and remains our key focus through our multiple offerings in the space. Overall, we believe allocating a percentage of assets to private debt with a long-term horizon can help investors generate income and help to better diversify their portfolios. Your financial advisor can help you identify the best allocation strategy according to your goals and risk preferences.
1 CPP Investment Board, 2022.
8 PitchBook Data/Desk Research 2023
9 Deal terms for illustrative purposes only. Source: Adams Street Partners 2023