Market conditions have evolved significantly over the last few years, creating attractive opportunities in certain areas of private credit, while the illiquidity premium is less favorable in others. As capital flows back into public markets and competition intensifies, understanding how to identify attractive sub-asset classes in private credit is essential for investors who are seeking solid risk-adjusted returns. With this in mind, we encourage asset owners to reassess their private credit allocations to ensure that their portfolios are optimally positioned going forward.
In this topical paper, we will discuss recent market conditions, private lending opportunities that benefit from thematic tailwinds, considerations for building an optimal private debt program, and our differentiated approach to private debt investing.
As public markets had stalled in launching new deals during COVID and throughout 2022, large corporate issuers increasingly turned to private markets to provide financing, spurring an opportunity for private credit managers to move further into the upper middle market (those that target companies with EBITDA greater than $100 million). But public markets woke up in 2024 as capital flows increased, with “risk-on” sentiment continuing into early 2025. This has begun to generate friction, where competition has arisen to reclaim pockets of the private credit market, and we expect this trend to continue.
At the same time, material public market spread tightening has impacted private lenders, especially those targeting larger deals. We also see the emergence of an increased tolerance for Pay-In-Kind (PIK) coupons, with borrowers allowed to defer some of the spread component of their interest (typically for a limited time). This is part of a much more aggressive stance from private equity sponsors on a variety of lending terms and reduces the attractiveness of the return profile of this part of the market.
These developments reinforce the need to be proactive with private credit allocations and the importance of diversified lending across collateral types.
While we believe that core middle market direct lending presents attractive opportunities, it is essential to access other sectors for their diversification benefits. There is a range of other options from infrastructure debt to specialty finance that diversify the collateral that you lend against. By broadening the focus, these additional investment opportunities can enhance portfolio resilience and reduce concentration risks.
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Real estate markets, unlike corporate markets, have experienced a dislocation with cap rates increasing dramatically, which has led to greater pressure on borrowers and existing lenders. We expect to see the Basel III Endgame exacerbate this and further impede bank lending given the risk weighting assigned to real estate assets. There is also the possibility that U.S. banks will sell down their troubled or non-core exposures due to increased scrutiny following the regional banking crisis in 2023.
These developments would increase the pool of assets that private lenders could access and provide an opportunity for experienced managers to step in and turn them around. Those that position themselves toward funds that can buy non-core and stressed assets are likely to benefit. The same goes for opportunistic funds that can provide bridge solutions to borrowers in need and step into new M&A, as traditional sources of commercial real estate lending remain stretched.
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Specialized pockets of infrastructure debt are appealing, bolstered by tailwinds from energy transition and digitalization. Given high capital expenditure needs, both areas have created compelling opportunities for private lenders to step in. For instance, the surge in AI development demands greater data center capacity (forecasted to triple from 2023 to 2030[1]), which in turn requires an increase in private infrastructure financing.
Infrastructure assets can offer greater stability demonstrated by historically stable cash flows, as these investments are focused on essential services and are often linked to long-term contracts. Although there has been a notable influx of senior financing into the renewable and digital infrastructure sectors, large equity requirements result in opportunities for second lien or subordinated financing for specialist managers to structure deals.
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Alternative asset-backed lending (sometimes referred to as private ABS) is also an attractive opportunity. These strategies are secured by tangible collateral, which can include inventory, accounts receivable, or equipment. This is an attractive opportunity to diversify via consumer, small balance real asset lending and true SME[2] exposure.
As ABS markets often face some market volatility, private solutions can offer greater flexibility and certainty of execution, which is appealing to borrowers. The compelling return premium over public ABS markets is due to the specialized structuring knowledge needed to exploit opportunities in the market, which also creates barriers to entry.
Although upper middle market lending appears less attractive, we still view direct lending that targets the “true” middle market space as a valuable core, income-focused holding.[3] Competition from public markets here remains relatively low, and as a result, spread compression has not been as pronounced. Without the same pressure from banks or public markets, leverage levels appear more conservative. Additionally, deal structures and covenants are less affected as lenders retain the ability to negotiate terms. This is important to ensure adequate protections on capital lent.
Value in private markets is not static; therefore, it’s important to stay up to date on market trends so that new commitments can be used to tilt your private debt allocation toward the most attractive opportunities.
In addition to heavily competed upper middle market direct lending, another area that warrants caution is regulatory capital financing. This asset class has historically benefited from favorable trends, most notably the increased capital requirements imposed on banks by Basel III. These regulations led banks to seek alternatives for raising capital, which created opportunities for bank capital trades, where private credit managers provided capital to help banks reduce the capital charge while maintaining their core customer relationships. While banks were willing to pay rates that exceeded the underlying risk about five years ago, spreads have tightened as this small market has seen a lot of aggressive new entrants.
Securing fee discounts can significantly enhance net returns. Fee negotiations can range from management fee discounts based on size to raising performance fee hurdles and lowering catch-up rates.
Loan managers who already have a full stable of credit analysts and existing relationships with upper middle market companies are moving into direct lending, causing fees to come under pressure. This is where working with advisors that can negotiate best-in-class fees is important, particularly where advisors work with large pools of capital, as aggregated capital investments lead to meaningful discounts.
We continue to find many attractive opportunities within private debt. However, as with any portfolio, diversification is key for optimal results. Ideally, this means a portfolio with a range of high conviction ideas diversified across borrower and collateral type, geography, sub-sector, credit quality, and vintages.
The private debt landscape is vast, and information is scarce, which means finding compelling strategies still requires significant resources and dedicated specialists. Many asset managers within the space continue to charge very high fees, significantly eroding investor returns. Investing at scale to negotiate preferential terms is critical to generate best-in-class net return outcomes.
Whether you are looking to invest in private debt for the first time or looking to review your allocations in this new environment, we believe WTW has the experience necessary to partner with you. At WTW, we have a team of dedicated private debt specialists who have helped our clients with selecting highly skilled managers, building highly diversified portfolios over time and investing at scale. Our key differentiator from our peers is our track record of innovating with private debt managers to design new and creative solutions to address our client’s ever-changing needs.
While we recognize the attractiveness of corporate middle market lending as a core, income-focused option, we believe that it is critical to explore other sectors such as real asset debt and specialty finance in order to enhance portfolio resilience and reduce corporate credit risk (where investors tend to be highly exposed). Engaging with our dedicated team of private debt specialists can help identify high-conviction investment strategies, negotiate favorable fee structures and build a diversified portfolio tailored to meet evolving financial goals.
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