Monthly CIO Note: The Private Debt Market Is Top Heavy. A Reallocation Is Necessary
Private debt has been making headlines for all the wrong reasons lately.
- From the collapse of companies backed by private debt funds, to commentary about contagion risk, it would be easy to conclude that private debt is not delivering on investor expectations.
- Headlines about collapse and contagion, however, only tell part of the story.
- The other part of the story, the part that doesn’t make the headlines, can be found outside the syndicated mega deals. In this part of the market, the story is one of growth, resilience, diversification, and rewards.
A Cautionary Tale of Scale
While private debt has deeper roots in the US, in Europe it emerged as a distinct asset class following the financial crisis. Prior to the global financial crisis, private equity-backed companies looked primarily to bank lenders and the public markets to finance deals. But stricter capital and liquidity requirements on banks opened up a debt financing gap that private debt funds have stepped in to. And today, private debt is one of the fastest growing asset classes in Europe, reaching an estimated EUR 400b in 2025.
This rapid growth has been fuelled by investors backing the biggest debt funds targeting mega deals. This has caused these funds, often managed by industry brand names, to explode in size. The typical investor thinking here is logical and straightforward enough: larger borrowers are more resilient, will suffer fewer defaults, and therefore offer a more favourable risk-reward profile.
However, data from the last crisis, when smaller syndicated loan borrowers experienced lower default rates, paints a different picture. As do more recent examples.
In September last year, US auto parts supplier First Brands collapsed and filed for bankruptcy with more than USD 11.6b in liabilities. While a host of large banks announced big losses, private debt funds were also on the hook for significant write-offs, having provided hundreds of millions in supply chain finance secured against opaque inventory and supplier contracts.
The event triggered a sell-off of risk assets amid fears of broader contagion. Companies primed for listings leveraged with private debt backing pulled their IPOs. Further, the event was a sign that when it comes to debt, size does not always equal safety. On the contrary, First Brands showed that size and the lending arrangements that accompany the biggest deals can often mean greater risk.
The good news for LPs is that there’s not just an alternative to upper market private debt, there’s a real reallocation opportunity. And that opportunity is in the lower to mid-market.
In the lower to mid-market segment, leverage is lower and businesses have more cash-flow growth to support deleveraging. Critically, all loans have meaningful early-warning covenant protections and traditional documentation controls. This is a central differentiator that needs to be understood.
The Mid-Market Edge
At the top end of the market, because of competition, deals are highly leveraged, and covenants and controls have been weakened. As seen with First Brands, this weakening can be fatal, allowing problems to spiral out of control before the sponsor or the lender can remedy the situation.
In the mid-market, no such competition, and therefore no such weakening, exists. Covenants and debt controls are stronger, which increases the alignment between the private equity backer and the debt provider. The early-warning system created by strong covenants, alongside robust documentation, gives an owner more visibility into an asset and therefore grants them more authority to direct remedial action. Strong covenant protections also ensure far better outcomes than weak or no covenants in the event of a default. On top of this, exposure to deals is often through the stronger senior secured tranche of the debt structure.
But there’s a catch.
The Complexity Premium
By contrast to the upper market, mid-market lending is more complex and harder to navigate. Deals are more bespoke, information is less transparent, and outcomes depend more on the manager’s judgement and experience.
This all makes it harder for an investor to identify and build a portfolio - and that’s where a multi-manager and its network of relationships comes in.
A multi-manager takes the pressure off an investor to identify and select managers in this sometimes opaque deal landscape. By utilising its networks to cast a wide net, a multi-manager can ensure an investor is properly diversified across a mix of managers. This diversification is important to avoid concentration risk. For example, two funds might have very strong track records and both look worthy of an allocation, but end up targeting the same types of deals. Or even the same deal. An experienced multi-manager can build a balanced portfolio of complementary managers and underlying deals.
And as well as the stronger covenants and documentation mentioned previously, deals in the mid-market are also less likely to be syndicated, enabling lenders to engage directly with borrowers, insist on a consistent quality of terms, and act quickly when problems arise.
When you bring all of these factors together, the downside protection in the private debt mid-market, especially when investing via a multi-manager, is far superior.
The story of First Brands is a warning to investors. But it is also a signal about where the real opportunity in private debt lies. Investors should stop looking up so much, and look down.
Towards diversification. Towards discipline and downside protection.
And towards the compelling and historically strong returns of the lower to mid-market.