Managing private credit through geo-political uncertainty

For investors looking at global private debt markets the current uncertainty associated with the broader geo-political outlook can make the nuances around investing more complicated. Indeed, such uncertainty makes the default position of just adopting a ‘set and forget’ approach to investing more problematic if the aim is to extract the optimal risk adjusted return. Yet there are several steps that investors can consider taking to try and manage the heightened risk associated with such an uncertain environment.

The Macro Backdrop

As with 2024, 2025 is likely to be a period characterised by ongoing excess demand for private debt but importantly without one of the ‘safety valves’ that previously existed. To better understand the dynamics going into 2025 it is useful to take a step back and review the supply and demand dynamics that evolved over the course of 2024. One of the key dynamics over 2024 was the high level of refinancing associated with the peaking in the US interest cycle. In 2024 activity within the US institutional loan market was dominated by the refinancing/extension and repricing of loan facilities (see Figure 1).

With the high level of ‘refinancing’ in 2024 the level of upcoming maturities (‘maturity wall’) for 2025-2027 has been materially reduced with ‘minimal’ maturities in 2025-2026 (see Figure 2).

Yet despite the pull forward in issuance from ‘out years’ acting as a partial ‘safety valve’ the excess demand for private credit caused spreads to continue contracting to the lowest levels in around 5 years. This raises an interesting question : With the excess demand for private credit in 2024 being met with a ‘pull forward’ in maturities via refinancings, what will act as the ‘safety valve’ in 2025 to help meet the expected ongoing excess demand?

While it may seem reasonable for there to be some further ‘pull forward’ of 2027-2028 maturities via refinancings, the key to meeting excess demand would appear to be a pick-up in Mergers & Acquisitions (‘M&A’) activity generating net new supply. Expectations of a pickup are particularly relevant given that M&A activity in 2024, though up on 2022 levels, was still relatively low (Figure 3). But is such a material pickup in M&A activity in 2025 likely in the current geo-political environment?

To address this question it is worth considering that, at a very high level, there are two main channels via which the policy backdrop can potentially impact on M&A activity. While closely linked these two channels will be referred to as ‘growth expectations’ and ‘uncertainty around growth expectations’. Making a distinction, while somewhat arbitrary, is relevant when considering M&A activity as arguably lower ‘growth expectations’ may have more of an impact on the price paid for a deal while greater ‘uncertainty around growth expectations’ may impact more on the desire of a potential acquirer to do a deal at all. Though the impact on ‘growth expectations’ remains unclear there is greater clarity that the current level of geo-political uncertainty will materially increase the level of ‘uncertainty around growth expectations’. Against a macro backdrop which creates greater ‘uncertainty around growth expectations’ any potential for a material pickup in M&A activity in 2025 will likely face greater headwinds. Unfortunately, in the absence of a material rebound in M&A activity ongoing excess demand raises the spectre that private credit spreads could prove less sensitive/responsive in the face of materially heightened geo-political uncertainties; i.e. spreads disconnect from ‘risk’ and remain lower for longer.

What Can Investors do?

In an environment of lower spreads that may prove less responsive to growing geo-political risks investors need to take greater care to ensure that they are able to maximise the Internal Rate of Return (‘IRR’) realised for the level of risk taken. There are two potential approaches to playing the risk associated with a period of potentially heightened financial volatility/dislocation.

The first approach to managing IRRs is to reduce the potential impact of dislocations on the pricing of private debt and realised IRR. To achieve this investors should consider the two dimensions associated with minimising risk. The first dimension is minimising the risk of a loss being realised in the event of a default by maximising the level of principal recovery post default. This can be achieved in several ways with the key one being by moving closer to the underlying collateral behind the loan and thereby effectively moving further up the capital structure. Doing so reduces not only the risk of ‘realising a loss on default’ should corporate defaults occur but also the sensitivity of pricing to market dislocations. An example of such a shift towards safety by investors would be a bias away from cashflow oriented lending and towards the collateral via more structured investments such as Asset Backed Lending. The advantage of such Asset Backed Lending is that not only is there specific collateral associated with the loan but the collateral is usually isolated within a bankruptcy remote vehicle.

The second dimension to risk minimisation is shifting the emphasis of the composition of the IRR to maximise the resilience of the underlying cashflows driving the IRR earned. This dimension to risk management involves more closely tying IRRs to the actual cashflows generated by the collateral. A greater focus on interest cash to generate IRRs, all else being equal, provides greater certainty around realised IRRs during periods of heightened uncertainty. By implication there is a corresponding bias away from strategies placing a greater emphasis on ‘equity like’ factors such as ‘pay in kind’ and warrants/equity to boost realised IRRs. Such a bias becomes particularly relevant when the premiums placed on equity are under downward pressure; i.e. equity premiums are being compressed.

The second approach to managing IRRs is to accept the greater level of potential cross-sectional volatility and take advantage of any market dislocations directly via managers pursuing more opportunistic strategies; i.e. embrace rather than avoid volatility. Given that ‘opportunistic’ is a very broad term it pays to be more specific regarding which types of strategies are best. Against such a backdrop of heightened uncertainty and ongoing excess demand in private credit markets arguably the preferred opportunistic investments are those that seek to take advantage of liquidity dislocations or liquidity driven events. Specifically, liquidity driven events refer to shorter term episodes where differences in credit supply and demand result in material pricing dislocations between debt sub-markets. To better understand the dynamic consider that the private credit markets are themselves a subset of the broader credit markets. Hence the distinction being made is that an overall excess demand within private credit markets does not mean that there is necessarily an excess demand for credit within all parts of either the broader credit market or indeed specific sub sectors within private credit markets. Liquidity differences will accordingly result in dislocations between debt sub-markets which investors can seek to opportunistically take advantage of as other players in the broader credit market, such as the banks, pull back capital from borrowers.

Though far from exhaustive there are three main ways that broader financial dislocation can provide opportunities for higher IRRs from private credit markets.

• New loan rationing as banks and other financial institutions ‘pull back’ from the syndicated and non-syndicated loan markets
• Pricing dislocation between public and private markets
• Banks or other stressed lenders selling individual or portfolios of loans at discounts to par directly via the secondary market

The common feature for all these strategies is that they seek to take advantage of dislocations in loan flows by being opportunistic liquidity providers to specific parts of the credit market; i.e. act as buyers when others are selling. By being positioned to take advantage of the opportunities provided by liquidity driven dislocations investors are better able to use uncertainty to boost IRRs in a lower IRR environment without necessarily assuming higher levels of overall credit risk.

A period where there are potentially low spreads and heightened uncertainty is not conducive to investors adopting a simple ‘buy and hold’ approach in mainstream private debt markets if the aim is to maximise the realised risk adjusted returns. Though the period going forward may be marked by a combination of lower spreads and heightened uncertainty there are still steps investors can take to maximise IRRs earned. Whether it be risk minimisation or opportunistic investing to take advantage of uncertainty the key is that investors need to proactively address how portfolios are structured. By ensuring they are proactively responding to changing market conditions investors place themselves in the best position to maximise the IRRs earned for the level of risk assumed within their private debt portfolios.