Riding the cycle: Strategies for private debt investors in a volatile market

At a Glance:

• Private debt markets are sensitive to economic cycles, with deal flow booming during growth phases and distressed opportunities increasing in downturns.
• Diversification and liquidity help stabilise portfolios and capture returns in volatile markets.
• Flexible structures and disciplined underwriting ensure long-term resilience and sustainable growth.

No longer niche, private debt has evolved into a critical asset class for institutional investors. Industry estimates project private markets growing from $13 trillion today to more than $20 trillion by 2030. But as economic cycles fluctuate, the balance of risk and reward remains in constant motion.

Larry Fink, the CEO of BlackRock, recently emphasized the importance of private markets in supporting growth during uncertain times. He stated, “The growth of private markets could mitigate the economic impact of wide U.S. deficits and high government debt levels.” But navigating the opportunities of this asset class demands strategy.

In this article, we’ll explore how economic cycles impact private debt markets and provide actionable strategies for institutional investors to ride the volatility and emerge stronger, no matter the cycle.

Why private debt markets are susceptible to economic cycles

Unlike public markets, where liquidity and pricing adjust in real time, private debt deals are governed by longer-term agreements, making them less responsive to immediate economic shifts and more vulnerable to cyclical changes.

Expansion phases

During periods of growth, businesses actively seek capital to fund their expansion, while investors are drawn to the surge in deal flow and the promise of attractive lending opportunities. These dynamics define the opportunities — and challenges — of this phase:

• Deals boom (and risks increase): Economic expansion drives borrowing as businesses seek financing to seize growth opportunities, including scaling operations, investing in technology, or pursuing acquisitions. However, this increased activity amplifies the risk of overleveraging, particularly when borrowers take on more debt than their cash flows can sustain under adverse conditions. During the mid-2000s, the leveraged buyout boom led private equity-backed companies to accumulate significant debt, contributing to elevated demand for private debt funding and exposing many firms to unsustainable leverage before the 2008 financial crisis.
• Credit quality strengthens: During economic upswings, businesses typically experience higher revenues and profitability, improving their ability to service debt obligations. This stronger credit quality makes private debt particularly attractive to investors, as the likelihood of defaults decreases and the overall risk profile improves.
• Competition compresses yields: The influx of capital into private debt during expansion phases often results in intensified competition among lenders. This competition can force yields to tighten, leaving less room for error in the event of a downturn. In 2021, private debt funds experienced record inflows, with many lenders agreeing to lower interest rates just to remain competitive, eroding returns in the process.
• Covenants tend to weaken: The race to deploy capital and secure deals often leads lenders to compromise on covenant protections. This trend became evident in the mid-2010s when the prevalence of “covenant-lite” loans surged, especially in leveraged loan markets. While these agreements can make terms more attractive for borrowers, they expose lenders to higher risks, particularly during periods of economic stress when defaults are more likely.

Downturns

Economic slowdowns reveal vulnerabilities in private debt portfolios but also present opportunities for those prepared to act decisively. These are the key dynamics investors encounter during contraction phases:

• Credit markets tighten: As economic uncertainty rises, lenders become more cautious, reducing the availability of credit. Historically, economic downturns have tightened credit access and exposed overleveraged companies, as seen in both the 2008 financial crisis and recent interest rate surges in 2023.
• Default spikes: Borrowers with high leverage or weak financial fundamentals are particularly vulnerable in downturns. In the early 2010s, following the European sovereign debt crisis, default rates surged in industries like manufacturing and transportation, where demand plummeted due to global economic stagnation. In these conditions, diversifying portfolios and avoiding overexposure to cyclical industries becomes vital.
• Distressed opportunities emerge: Downturns are a fertile ground for investors skilled in identifying and managing distressed debt. Businesses under financial strain often look to restructure their obligations, offering savvy investors the chance to acquire assets at discounted valuations. During the oil price crash of 2014–2016, investors in distressed energy debt capitalised on the sector's volatility, achieving significant returns as energy prices rebounded. However, these opportunities require specialised expertise in restructuring and a strong tolerance for risk.

How to stay ahead of economic cycles

Economic cycles are inevitable, but with proactive strategies, institutional investors can mitigate risks and capitalise on opportunities in any phase:

• Diversify across sectors and geographies: Concentration risk can amplify the impact of economic downturns on a portfolio. Investors should aim to diversify across industries with varying levels of sensitivity to economic cycles. Sectors such as healthcare and technology, which often exhibit resilience in contractions, can offset exposure to more volatile industries like retail or hospitality. Geographic diversification also helps, as different regions may experience economic cycles at different times.
• Maintain disciplined underwriting standards: In both booms and downturns, adhering to rigorous underwriting processes is essential. During expansion phases, investors must resist the temptation to relax due diligence to chase deals. Assessing borrower fundamentals, understanding industry dynamics, and structuring deals with adequate covenants can help ensure portfolios are resilient when economic conditions shift.
• Build liquidity reserves: The ability to deploy capital quickly during downturns is a critical advantage. Building dry powder during expansion phases allows investors to capitalise on distressed opportunities when valuations drop. Private debt funds that entered the market in 2009 were able to achieve outsized returns by providing liquidity when others pulled back.
• Embrace flexible investment structures: Flexibility in deal structures can provide a cushion during economic volatility. Senior secured loans or asset-backed financing offer greater downside protection than subordinated or unsecured loans. These structures allow investors to participate in growth opportunities while limiting potential losses.
• Monitor leading economic indicators: Staying ahead of economic trends requires careful observation of leading indicators such as interest rate changes, unemployment rates, and corporate earnings. Rising interest rates in 2022 and 2023 signalled increasing borrowing costs, which impacted private debt portfolios. Adjusting exposure in response to these indicators can help mitigate risks and optimise returns.
• Leverage technology for risk assessment: Advanced analytics and AI-driven models can enhance credit risk assessment, providing early warnings of potential borrower stress. Tools that aggregate market and borrower-specific data can offer investors actionable insights, enabling them to make informed decisions in both expansion and contraction phases.

Monitor illiquidity premia to uncover opportunities: Private corporate debt spreads re-price faster than other asset classes, closely aligning with public credit spreads. By tracking fluctuations in illiquidity premia, investors can identify periods of elevated market volatility or constrained capital availability, which often present attractive opportunities to capture higher returns while being compensated for additional risk.

Illiquidity premia across private corporate debt, real estate finance, and infrastructure debt vary through economic cycles. Periods of elevated market volatility or reduced capital from traditional lenders often coincide with the highest illiquidity premia, offering key insights for timing portfolio adjustments.

Turning volatility into opportunity

The growth of private debt markets brings immense potential for returns but also highlights key risks like rising defaults and overleveraging. Institutional investors must adapt by leveraging liquidity and targeting opportunities in resilient sectors. For those who can balance yield pursuits with prudent strategy, private debt offers transformative potential to redefine investment strategies and mitigate risks in an increasingly volatile economic environment.

For more insights into Australia’s private debt opportunities, contact us.