Private credit’s AUM trap

The private credit market is broad, and the liquidity and credit quality concerns that have attracted public attention are predominantly concentrated at the large-cap end of the market. Liquidity pressure points have been most evident in the US, where semi-liquid and interval funds have grown rapidly. These evergreen vehicles are far less prevalent in Europe.

At Investec, for example, we are focused on the lower mid-market in the UK and Western Europe where there has been no shortage of transaction volumes, enabling a discerning approach when deciding which businesses to finance.

Our team consistently reviews around 600 financing opportunities annually, and completes around 25 to 30 new deals, and the same again in terms of add-ons for the existing portfolio. We hold around 140 borrower relationships and average exposure to any single borrower is less than 1%.

Upside for lenders is capped, and a single write-off can have a disproportionate impact on returns.  In contrast, for equity investors a small cohort of outsized deals drives performance. Diversification has always been non-negotiable for lenders, and is offering a degree of protection as AI disruption impacts some sectors more than others.

As for underwriting standards, approaches to risk and underwriting vary significantly across the direct lending market, and there will be meaningful dispersion in credit quality observed across manager portfolios. It is thus a misconception to claim that underwriting quality is somehow weaker in direct lending.

There is a misconception that the lower mid-market is underserved because it presents higher risk, but the reality is that it is a market containing many high-quality assets, and one that presents compelling value for lenders.

Investec, for example, recently underwrote senior debt facilities to support CBPE Capital’s investment in Brookbanks, a multi-disciplinary consultancy. The deal’s financing priority was to source flexible debt capital that would enable Brookbanks to develop and grow its integrated consultancy platform³.

In the large cap segment of the market, by contrast, lenders compete for a relatively small number of opportunities and win deals on pricing, leverage and terms.

Lower mid-market lenders can thus secure better terms and pricing because competition for deals is less intense, and because sponsors backing smaller companies prioritise other lender qualities.

Recently, Investec curated a bespoke financing package to support long-standing client Triple Private Equity’s acquisitions of Derivia Intelligence, Extel and Euromoney.

The package comprised acquisition finance facilities at the operating company level and a fund finance facility, backed up with hedging and foreign exchange support to convert euro-denominated fund financing capital into sterling-denominated acquisition finance⁴.

This deal reflects how lower mid-market managers place a premium on lenders that can leverage comprehensive capabilities to offer flexible finance.

So why do more lenders not operate in the lower mid-market space? One reason is the investment and patience required to build a platform of the required depth to address this segment adequately.

As the market has grown, it is natural that managers have sought ever-larger deals to maximise deployment and AUM growth.

After evolving from a cottage industry into an asset class that is on track to achieve AUM of $4.5 trillion by 2030⁵, the next phase of private credit’s development will be shaped by underwriting track record and realised returns, rather than growth in AUM.

In the large deal market, where transaction flow is limited, and several lenders will bid for the same deals, pricing, leverage and documentation become the main points of differentiation. This is a dynamic that can begin to compromise credit discipline.

This has played out in practice. Growth in AUM has pushed direct lenders to compete for large-cap deals with broadly syndicated loan (BSL) markets, and participating in this competitive space has, inevitably, meant that direct lenders have had to tighten pricing and loosen covenant protection.

Although the market remains fundamentally sound, returns will likely moderate. During the last decade of strong growth the asset class has generated average annual returns of 8.8 percent⁷, beating other fixed-income asset classes. In a more mature and competitive market, where competition to win deals is tougher, returns will not come as easily.

In addition, geopolitical instability will likely elevate the rate of loan distress even in conservative portfolios, eroding returns further.

This is likely to reinforce market bifurcation. Managers that have a consistent and differentiated position, as well as a track record of delivering strong returns will stand out. Managers that manage large pools of capital but lack differentiation may struggle.