Borrowers likely to come under stress as economic growth slows and defaults rise, says top alternative investment manager
For the next five years, KKR expects private credit to rank among the top performing alternative investment sectors. However, amid a still-unclear economic outlook, the asset management giant is cautioning investors that defaults will also increase.
“We believe credit offers a better risk-return proposition than equities in the near term due to the combination of higher yields, debt’s position in the capital structure, the contractual nature of returns in credit, and the pressure equity valuations are under as long as rates remain elevated,” according to the firm’s latest letter to credit investors.
The alternatives company, which provides real estate, private equity, private credit, and other illiquid assets, anticipates that junior debt will have a CAGR in the mid-teens over the next five years.
According KKR's report, private credit CAGR is predicted to increase to 11.1% between 2023 and 2028, compared to 7.5% between 2017 and 2022.
KKR also predicts that between 2023 and 2029, the S&P 500 index's annual growth rate would decline from 9.6% to 5.2%, while private equity's CAGR will dip from 16.4% to 12%.
Additionally, the CAGRs for unlisted real estate and infrastructure will drop from 10.3% to 8.7% and 10.3% to 8.3%, respectively.
Given the strain on traditional banks, KKR predicts that private lenders will increasingly step in to fill the credit vacuum. Private credit funds are currently being "chased by borrowers who are happy to pay a premium for scarce financing," according to the research, as liquidity has grown more difficult to come by.
Read more: Private credit funds adapt to demand for liquidity
According to KKR's estimations, direct lending organizations contributed over 50% of the new loans issued in Europe during the third quarter of 2022.
Investors' trust in the private credit sector shouldn't be impacted by the banking sector’s recent crisis in confidence, says KKR. Due to a sizable percentage of its deposits not being insured, Silicon Valley Bank was noted as being an anomaly in the banking industry.
“Looking at the overall banking system in the United States and Europe, it is clear to us that this is a liquidity crisis, and not yet a credit crisis,” the report said.
The failure of SVB, however, ought to serve as a warning to investors that they still need to take a defensive stance. Investors should search for opportunities in top-notch companies with reliable cash flows and safe margins.
“We do think it is imperative that investors learn to tune out the lure of cheap valuations until they understand whether there is value in the price or if the price reflects the value,” the report concluded. “The world is still uncertain in many ways. It seems likely that borrowers are going to come under increasing stress as central bank tightening slows economic growth, and we expect defaults to rise.”
