By 2028, the global market is expected to hit $US3.5 trillion as this asset increasingly meets the needs of investors wanting higher yield and diversification from public credit.
As traditional banks retreat from lending markets, private debt is stepping in to fill the gap. From nearing $US2 trillion globally today, private debt’s assets are expected to reach $US3.5 trillion by 2028. Why is this?
Private debt typically offers higher yields than public credit, partly due to the illiquidity premium investors receive for committing capital to less liquid loans, as well as a complexity premium for the expertise required to access, source and structure these loans.
Furthermore, it often finances smaller and mid-market companies with more limited access to capital markets that can provide attractive risk/return profiles and face less competition among lenders. This creates opportunities for higher yields and more favourable deal terms.
Additionally, investors usually hold private loan funds to maturity, focusing on cash flows rather than market price fluctuations. This makes private debt less sensitive to short-term market volatility than public credit.
The cash yield on buy-and-hold portfolios also provides a tangible income, making it an ideal product for retirement and for institutions requiring recurring income.
Private debt encompasses various sub-strategies, each responding to different performance drivers. Direct lending – the largest segment – involves non-bank lenders providing loans directly to mid-market companies, often as senior secured loans.
Mezzanine debt typically sits lower in the capital structure, carrying higher risk and return. Distressed debt involves purchasing the debt of companies in financial distress or bankruptcy, potentially offering high returns but with significant risk and complexity.
Specialty finance includes niche lending areas such as consumer finance, asset-backed lending, litigation finance and trade finance. The combination of high-risk/reward pockets alongside larger segments delivering more stable cash flows and lower default risk creates an appealing mix for investors.
Post-financial crisis regulations have constrained the ability of banks to lend to certain borrowers, creating a funding gap that private debt funds have filled. Facing fewer regulatory capital requirements and limited or no distribution/underwriting risks, these funds are often more flexible and responsive to borrower needs.
As opposed to public markets, where terms are relatively standardised, private debt agreements are often bespoke, allowing lenders to negotiate tailored terms, covenants and collateral packages that better protect their interests. This flexibility can lead to stronger credit protections and more stable cash flows than those typically found in public credit.
Many private debt instruments are also floating rate with a base rate floor, providing a natural hedge against rising interest rates and inflation.
Due to differences in liquidity, borrower profiles and pricing mechanisms, private debt exhibits limited correlation with public credit, making it an attractive diversification tool within fixed income portfolios.
Diversifying public credit exposure
Public credit instruments, including Treasuries, are sensitive to market volatility, interest rate fluctuations and geopolitical events, which can lead to significant price swings. Ballooning deficits and weakening political stability in developed market countries are increasingly impacting Treasury markets and shaping central banks’ agendas.
Public credit markets are also highly competitive and efficient, often resulting in tighter credit spreads and lower risk premiums. This compression limits the potential for outsized returns and makes it more difficult for investors to differentiate performance.
The equity/bond correlation is increasingly volatile and unreliable, leading investors to seek more all-weather diversification.
With investment-grade markets highly correlated to sovereign debt and high-yield bonds representing a relatively small portion of credit markets, investors seeking alternative fixed-income options see private debt enhancing diversification and helping improve risk-adjusted returns in fixed-income allocations.
Institutional investors, particularly pension funds and insurance companies, are more involved with a more integrated approach to credit investing, making less distinction between public and private options. These investors tend to have long-term investment horizons and low liquidity needs.
In addition, more sophisticated borrowers are resulting in a more competitive environment. They are exploring both public and private credit options to meet their financing needs, leading to an environment where private lenders are striving to offer timely and more flexible credit solutions.
Other influences impacting the market are regulatory and economic factors operating in greater harmony, while economic conditions impact both markets simultaneously. For example, higher interest rates may lead public borrowers to seek private alternatives.
Technology and data analytics are also being used to seek a more holistic assessment of credit risk across both markets. This is still at an early stage as access to data remains limited in private credit.
Finally, investor education and awareness are improving, with investors becoming more familiar with the benefits and risks of private credit, increasingly considering it a credible and reliable alternative.
As a result, private and public credit spreads are slowly converging. Morgan Stanley estimates that direct lending spreads on leveraged buyout (LBO) loans versus comparably rated syndicated loans have shrunk by 40 basis points over the past three years to March 2025. Similarly, the global credit rating agency KBRA sees a similar convergence between direct-lending middle-market loans and syndicated loans.
