Private markets face challenge of deteriorating economy in 2024

After benefiting from higher interest rates and tighter lending conditions in 2023, the private credit sector faces challenges in the year ahead from a deteriorating economy.

“For the first time in a long time, private assets are facing an uphill climb as we look to 2024,” said Ash Lawrence, senior vice-president and head of AGF Private Capital, with AGF Investments Inc., in the firm’s 2024 outlook report.

Higher interest rates have boosted yields for private credit investments, and lending opportunities have increased as banks and other traditional lenders have reduced their loan activity. This was evident in the U.S. following the collapse of Silicon Valley Bank in March, and Lawrence said Canada has seen a similar trend, with banks reducing exposure and focusing on higher-margin clients.

If the economy continues to deteriorate in 2024, lending conditions could tighten further, he said.

But while an economic downturn creates opportunities in private credit, the risks also increase.

A report on Tuesday from DBRS Morningstar warned the “golden age” of private credit may be coming to an end. The rating agency’s 2024 outlook for business development companies predicted that the positive backdrop that boosted private credit this year may not hold up.

“We expect business development company peak earnings of 2023 will be challenging to sustain through 2024 as base rates level off or decrease and credit spreads tighten to normalized levels from competition,” said Watson Tanlamai, vice-president of the global financial institutions group with DBRS Morningstar, in a release.

Similarly, a report this month from S&P Global said private credit’s run faces challenges in the year ahead. While opportunities in the sector remain “robust” after a banner 2023, S&P warned about rising default rates.

“Financial risks weigh more on the credit quality of borrowers with weak business risk profiles or high leverage,” the report said. “In particular, companies issuing floating-rate debt, such as from private lenders, will be vulnerable to the higher cost of funding amid higher-for-longer interest rates.”

As a result, the rating agency expects the trailing 12-month speculative-grade corporate default rate to reach 5% in the U.S. by September 2024 (up from 4.1% in September 2023) and 3.75% in Europe (up from 3.1%).

For investors, examining the approach of private credit fund managers will become more important next year, Lawrence said.

“When there is a level of stress in the environment, private lenders need to have the skills necessary to properly underwrite and stress-test a borrower’s credit, and to structure loans that provide the right protections and risk mitigation to avoid negative outcomes,” he wrote.

Still, he said there’s potential for solid returns in private credit next year, as yields remain attractive and the asset class sees growing demand from institutional and retail investors seeking diversification.

Private equity, on the other hand, has struggled amid higher rates and would benefit from monetary easing. Deal activity has cratered in the last two years, as most transactions use leverage, and valuations have been affected.

“The correction in the public markets is beginning to translate to moderately lower private equity valuations,” stated BlackRock’s 2024 private markets outlook. “After rising steadily since the global financial crisis, valuations declined in 2023.”

With fewer exit opportunities, limited partners are turning to the secondaries market for liquidity and to meet distribution requirements, the report said, creating buying opportunities. BlackRock said it expects deal activity is likely to increase in 2024.

Lawrence said an economic slowdown could lead to more downward pressure on portfolio valuations and serve as “the catalyst for a new buying cycle later in the year. Downturns more often than not tend to produce opportunities for those who have dry powder (i.e., cash) to deploy,” he wrote.