THE IMPACT OF RATE CUTS ON PRIVATE CREDIT
Posted on January 27th, 2025
The ‘new normal’ of near-zero base rates came to an end almost two years ago, with a surge in rates since supporting compelling all-in gross yields in the private credit market. Spreads have compressed somewhat since rates peaked, with the upper end of the middle market private loan space being most impacted, and gross yields are now down from ~12.5% closer to ~10.5% on senior secured unitranche loans. So, what is the outlook? In this piece we examine expectations and the opportunity as we move into 2025.
What are expectations?
Expectations are for lower base rates in the years ahead and neutral rates are currently considered to be around 3% and 2% for the US and Europe respectively. These levels are considerably higher than the near zero-base rates experienced through the decade to the beginning of 2022, and is currently delivering attractive all-in yields of between 8 – 10% for senior lending transactions, assuming that spreads remain unchanged from today’s levels.
The lower spreads and more stable interest rate environment have given borrowers more breathing room to opportunistically consider refinancing – given the typically floating rate nature of the asset class – helping to buoy up deal activity. Market activity has therefore seen elevated refinancings as a share of total deal activity, although M&A is picking up YTD as well (see chart below).
Source: Copyright. Bloomberg Finance L.P.
Refinancings often provide an incumbency advantage to the existing lender, as sponsors and borrowers seek to minimise the complexity of switching provider. The incumbent lender’s deep insight into the borrower’s existing credit health can also help to derisk the follow-on transaction from the lender’s perspective.
While banks have been re-entering the market to again compete with private lenders, they have not been able to fully regain old ground. Speed, flexibility and certainty of execution remain highly valued criteria in lender selection and these attributes have served direct lenders well in deal activity and relationship building during the significant bank retrenchment seen from 2021 through 2023.
Source: Copyright. Bloomberg Finance L.P
What is the opportunity?
The market opportunity therefore remains compelling across the private credit spectrum. Attractive rates in the senior space allow for a focus on quality via large, market leading managers. These managers are also well positioned to benefit from the highlighted incumbency advantage where they have existing loans in place with the best quality private equity managers.
The bottom line? Private equity dry powder remains at high levels and private lenders are in a strong position to be able to capitalise on this market opportunity going forward.
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