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Finding opportunity on the horizon

Principal Alternative Credit - 2025 Outlook

December 23, 2024
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The past year was filled with plenty of events, but their market impact turned out to be less eventful than many would have expected. Economic uncertainty and geopolitical risks failed to derail steady performance across most asset classes. Public markets performed well, with credit spreads marching tighter and equities climbing higher throughout the year. The markets belief in a soft landing and the Federal Reserve’s (Fed) ability to engineer a move toward target inflation, along with reasonable employment growth, spurred the positive sentiment.

That may have been the easy part—the early stages of declining inflation and modestly rising unemployment. Now that the Fed is moving along its path to a lower Fed Funds target rate, the standard playbook doesn’t seem to be in play. With interest rates remaining elevated, the market seems to be struggling to digest the ability of the Fed, in conjunction with continued fiscal stimulus, to really curb inflationary pressures back to the desired long-term target.

What does this mean for private assets and specifically middle market direct lending? Though the picture is never as vivid as we would like, it’s likely the path to achieve economic recovery and resiliency in the new year will have its challenges. However, given the current state of the economy and markets, along with expectation for conditions to remain “reasonable” supported by an easier Fed, loan repayment and capital recycling has begun to increase, something we expect more of in 2025. This aligns with an expected increase to more typical levels of mergers & acquisition (M&A) and leveraged buyouts (LBO) activity.

Loan repayment and effective life
September 2005 - June 2024

Loan repayment and effective life for September 2005 - June 2024
Source: Cliffwater. As of 30 June 2024.
*Cash inflows from maturing loans, prepayments, and sales divided by total investment cost.
**Equal to the reciprocal of the first footnote.

Conclusion

With investors looking for diversification and incremental return, some will search for other private asset classes that may be more esoteric than middle market direct lending. However, investors that stick with or begin an allocation to middle market direct lending should be rewarded and likely benefit from greater capital deployment in the coming year. The recent and current vintage of direct lending should also be attractive with good relative value and credit structures, along with an expected transition to a more constructive economic outlook. In addition, the secular support of this asset class is still in its early stage. Very few investors are at their target allocation, while many are planning to increase the allocation in coming years, and others are just beginning investment in the asset class. It is and will remain important for investors to evaluate and understand how different segments of middle market lending represent different diversification and alpha opportunities. With rates likely remaining elevated through 2025 compared to interest rate standards of the past decade, and the substantial spread relative to public high yield loans, the income from middle market direct lending should be quite attractive. This should result in yields remaining at or near double digits and a foundation for investor returns.

For more of our thoughts on the Principal Alternative Credit outlook for 2025, read our full perspective here.

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Risk Considerations
Past performance is no guarantee of future results. Investing involves risk, include possible loss of principal invested. Investments in private debt, including leveraged loans, middle market loans, and mezzanine debt, are subject to various risk factors, including credit risk, liquidity risk and interest rate risk.

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MM13781-01 | 12/2024 | 4038152-122026