(Bloomberg) -- Private credit investors in Europe are abandoning leveraged plays to try to get ahead of a potential wave of defaults.

Given a choice to buy funds with or without added leverage, fewer investors are opting for the amped-up versions, according to direct lenders that have just completed new rounds of fund-raising. 

Private credit funds, which generally invest in loans to mid-size companies, can use borrowed money in addition to the capital they receive from investors. These so-called levered sleeves have enjoyed popularity as a way to boost returns into the double-digits as the private credit market boomed. The downside is they magnify losses in a bear market.

“We used to offer a levered sleeve, but there was much less demand for this on our most recent fund,” said CAPZA managing partner Guillaume de Jongh, which just closed its sixth fund this month. “The idea of rates staying higher for longer is settling in and that means potentially more defaults further down the line.”

The European Central Bank moved to lower interest rates this month before the Federal Reserve and the Bank of England, but left investors guessing how quick it will be to loosen policy further with inflation still running hot.

While regulators in Europe and the US have put limitations on the maximum amount of leverage some funds can carry, managers can take very different approaches when deciding how much to borrow within those bounds. 

“Some managers have gone overboard with the level of leverage,” said Florian Hofer, a managing director at Golding Capital Partners.

Until now, the high-rate era has been a windfall for the $1.7 trillion private credit market. Lenders have blasted through so-called hurdle rates, the point where they can begin to collect profit — or “carry” — on their returns. The industry has enjoyed returns rivaling private equity.

But a long period of elevated rates could tip more companies into default and spell the end of the boom. Already there are signs that some private credit borrowers are straining under high debt loads. Some funds have amassed larger rates of non-accruals. Firms are also taking over struggling businesses.

Adding an extra layer of debt at the fund level could complicate recovery if a borrower, or several, run into trouble. Paul Spendiff, head of business development for fund services at Ocorian, says increasing default rates could impact levered funds disproportionately. 

“I can certainly envision scenarios in which levered investors will need to fund capital calls that directly go to the bank after some trouble within the portfolio,” said Christian Wiehenkamp, chief investment officer at Perpetual Investors.

For now, the trend for leverage-free investing seems limited to Europe. In the US — where levered sleeves may amplify returns by as much as 3% according to one report — fund managers say they remain largely in favor. In Europe, leverage juices returns by a much more modest margin, of less than a percentage point, according to the same report.

Trading safety for returns made sense when investors needed to compensate for near zero rates in the easy-money era. 

Now costs — and risks — have risen. Some managers, for example, charge on both the equity capital committed and the leverage borrowed from banks.

“The cost of leverage has however gone up, so I would assume that it is becoming somewhat less interesting for investors overall,” said Sebastian Schroff, lead portfolio manager for global private debt at Allianz Global Investors. He prefers to invest in private credit without leverage.

Deals

  • KKR & Co is nearing a deal to buy about €1.9 billion of loans from Orange Bank SA as the unit of the French telecom company pulls out of the financial services business
  • A group of private credit lenders has provided $1.4 billion to DuBois Chemicals to refinance existing debt
  • Carlyle Group Inc.-backed Veritas US Inc. and its lenders are in a stand-off over how to deal with the company’s debt load
  • RSK Group Ltd, a UK-based environmental consultancy, is getting a £500 million preferred equity investment from a consortium led by Searchlight Capital Partners and Ares Management Corp.
  • Team Global Express, an Australian transport and logistics firm, has received A$40m of mezzanine debt from Commonwealth Bank of Australia and Income Asset Management
  • ViaPath Technologies, a company that provides phone and communications services to prisoners, is closing in on a nearly $1.5 billion refinancing
  • The Adani Group unit that controls a major Australian coal port has obtained a private credit loan of about A$500 million
  • Stifel Financial Corp. and Lord Abbett & Co. are teaming up on a joint venture for private credit

Fundraising

  • Private credit manager BPEA Credit announced the first close of its short term fund
  • Credit manager Sona Asset Management raised $800 million in a bid to provide custom financing to businesses struggling to access cash
  • Private credit firm Arcmont Asset Management has received approval from the UK regulator FCA to launch a Long-Term Asset Fund
  • Vivriti Asset Management Pvt. is launching a new private credit fund for investing in small and medium-sized Indian companies
  • Deutsche Pfandbriefbank AG is sounding out investors for a real estate debt fund of as much as €500 million, as the German property lender aims to diversify its business model
  • Antares Capital is looking to raise as much as $6 billion for its third senior loan fund despite a cooldown in private credit fundraising
  • Pemberton Asset Management plans to raise more than €4 billion for the fourth vintage of its mid-market debt strategy
  • Next Edge Capital is halting redemptions in its flagship private credit fund following a spike in investors trying to pull their money out
  • MidOcean Partners LP said it raised $765 million in commitments for its opportunistic credit fund, which will invest in mid-sized businesses including ones that are likely to pursue so-called liability management exercises
  • French firm CAPZA has closed its sixth private debt fund at €2.5 billion
  • Asset manager Ninety One is planning to close its first asset-backed private credit fund focusing on Europe in Q3 this year

Job Moves

  • Man Group Plc hired Tessa Orlebar, who most recently worked for Barclays Plc, as hedge funds compete to lure experts on one of Wall Street’s hottest trades: significant risk transfers
  • Barings has hired Patrick O’Sullivan from Schroders as head of international insurance solutions, a newly created role
  • Daniel Abercromby has joined Gibson Dunn & Crutcher as a global finance practice partner in its Hong Kong office

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