Gridlock

Private equity transaction volumes remain limited despite predictions for a boom in 2025. With interest rates remaining elevated and the economic backdrop increasingly uncertain, executing acquisitions and IPOs is proving a challenge, leading financial sponsors to hold portfolio companies for longer. This impasse has significant ramifications, not least for credit markets. The lack of fresh deals leads to an absence of new supply for the leveraged credit markets that generally provide funding for M&A and LBOs. Meanwhile, elevated yields have increased investor demand for credit, creating the supportive supply/demand dynamic that helps constrain spread widening. Even with the recent volatility relating to fluctuating global trade policy, that’s what we’ve seen in credit: relatively limited defaults, unremarkable spreads, but compelling coupon income.

An Absence of Deals

It’s no secret that M&A and LBO activity has struggled to recapture the heady days of 2021 when low interest rates and a flood of liquidity supported record deal levels – and the accompanying debt issuance. The post-pandemic deal boom came to a screeching halt in 2022 as central banks raised rates in an attempt to curtail rampant inflation. Private equity funds have since struggled to exit portfolio companies at their desired valuations and new deals have dwindled. Though we’ve seen some signs of recovery, predictions for a resurgence in 2025 appear to have been overly ambitious. (See Figure 1.)

Figure 1: Deal Activity Has Been Muted

Source: PitchBook LCD, as of March 31, 2025

All Roads Lead to Rates

In 2022-23, an increase of over 500 bps in the fed funds rate marked an end to the era of ultra-cheap leverage that commenced in the aftermath of the Global Financial Crisis. Private equity sponsors accustomed to getting seven turns of leverage for buyouts and paying a 4% coupon on their loans soon faced a new environment where that leverage level was largely unrealistic and their interest costs had doubled.¹ While the rapid rate increases were designed to halt very apparent inflation, market participants have been caught off guard by how long it would take for rates to moderate again, with SOFR still well above 4%. (See Figure 2.) What’s caused this prolonged elevation? Chiefly, the surprising strength of the U.S. economy, led by a strong consumer benefitting in many cases from mortgage rates locked in at record-low levels. Rather than the anticipated economic slowdown as interest rates rose, strong jobs data and ongoing price increases have made it challenging for the U.S. Federal Reserve to make meaningful rate cuts. Whereas the Fed had latitude to become more accommodative during the Covid-19 crisis, now that prices of consumer goods have already risen significantly over the last few years, any policy change that fuels inflation may cause further struggle for lower/middle-income consumers.

Figure 2: Base Rates Remain Elevated

Source: Bloomberg, as of April 21, 2025

Capital Cost Mismatch

Crucially, higher interest rates impact the salability of private equity portfolio companies. With a drastically higher discount rate than that between 2009-21, the valuations portfolio managers believe their holdings are worth have been challenged: potential sellers refuse to compromise while potential buyers aren’t eager to increase their bid. Because of this deadlock, hold periods have increased, with almost 30% of portfolio companies in 2024 having been held for over seven years. (See Figure 3.)

Figure 3: Portfolio Companies Are Being Held for Longer

Source: PitchBook, as of September 30, 2024

What’s led to this impasse? Prospective sellers purchased companies at a much lower cost of capital than potential buyers now face to fund purchases of the same assets, leading to a mismatch. Notably, over 60% of buyout deal returns in the low-interest-rate era were attributable to broad market multiple expansion and leverage.² With these levers challenged, a private equity manager may need to sell to a buyer with a lower cost of funding to achieve their desired exit multiple: a situation that might not be forthcoming. Private equity managers can’t get the exits they want and could face a renewed lack of buyers as uncertainty over trade policy pushes potential buyers to the sidelines.

Seeking Distributions

As hold periods increase, private equity LPs are left waiting for distributions: in 2024, distributions from buyouts funds dropped to just 11% of fund NAV, down from around 30% in 2021. (See Figure 4.) As pressure mounts to improve DPI (a measure of distributions from a fund), private equity managers are seeking creative ways to return capital to LPs without selling assets at undesirable valuations. This includes a variety of fund financing methods, perhaps most prominently NAV financing. NAV loans allow sponsors to borrow money against the value of their fund portfolio, with this capital generally used to fund value-creation initiatives at portfolio companies and to make distributions to investors. Continuation vehicles have also soared in prominence, providing a way for GPs to retain promising assets after the end of a fund’s life, with existing LPs given the opportunity to sell their share. These methods of liquidity generation may provide LPs with the capital to invest in new buyout funds (and thus support transaction activity) but may do little to ease the backlog of private equity portfolio companies.

Figure 4: Private Equity Fund Distributions Have Been Limited

Source: Preqin; MSCI; Bain analysis³

Lenders Await Supply…

With hold periods increasing for portfolio companies, the leveraged credit markets have mostly seen supply in the form of refinancings, rather than debt issued to fund acquisitions: refinancings have constituted over 85% of supply in the loan market so far this year.⁴ Transactions that effectively just extend the maturities of existing debt don’t directly increase market size, leaving investors fighting over the same amount of paper. In the three years ending in March 2025, the U.S. loan market grew by a total of just 6.1%.⁵ (See Figure 5.) Meanwhile, the prospect of high single-digit coupons has enticed income-seeking investors.

Figure 5: Limited New Supply Has Constrained Loan Market Growth

Source: Credit Suisse Leveraged Loan Index, as of March 31, 2025

…While Investors Demand Credit

While supply has been limited, demand for credit has been strong; for exactly the same reason! After being stuck with mediocre yields for over a decade, credit investors have jumped at the chance to buy high yield bonds and senior loans at a roughly 8% yield, and, of course, an even greater yield in private credit.⁶ Demand for high yield bond and senior loan mutual funds was strong in 2024 while particularly remarkable has been the record levels of CLO creation, which has turbocharged demand for senior loans. (See Figure 6.) Though high yield bonds lack a structural buyer akin to CLOs, the limited growth in this market – exacerbated by issuers leaving the market upon achieving an investment grade rating – means the supply/demand balance is also tilted toward demand. Recent market volatility may briefly take the edge off the demand for credit, as shorter-term capital pulls back, but elevated credit yields are likely to be a persistent tailwind for credit demand.

Figure 6: CLO Creation Surged in 2024

Source: PitchBook LCD

Technical Support

When supply is low but demand and rates are high, we have the situation we’ve been experiencing over the last few years: unexciting credit spreads but attractive yields. Even with the recent increase in spreads, over half of the yield on high yield bonds is currently coming from rates compared to only 25% on average since 2010. (See Figure 7.) Happily for investors, elevated rates are bumping the yield on high yield bonds to around 100 bps above the average level since 2010.⁷

Figure 7: Credit Yields Are Being Driven by Base Rates

Source: ICE US High Yield Index

Uncertainty Redux

Adding to the complex backdrop, markets were roiled in April by seismic shifts in global trade policy. An already-limited M&A market immediately paused: it’s extremely difficult to underwrite new deals when economic conditions are entirely uncertain and debt costs are rapidly fluctuating. Even prior to the tariff announcement on April 2, we’d seen the lowest number of M&A transactions in over a decade, with this deal impasse constraining supply in the leveraged credit markets.⁸ As managers wait for new deals, a prudent approach may be to avoid compromising on underwriting standards in grasping for limited supply, while also cautiously accessing dislocation in the secondary market as it presents itself. Trade policy is a new variable for investors to contend with, but as Howard Marks recently reminded us ‘‘there’s no such thing as foreknowledge here, just complexity and uncertainty, and we must accept that as true.’’

Credit Markets: Key Trends, Risks, and Opportunities to Monitor in 2Q2025

(1) The Backdrop Is Even More Uncertain than Usual

Volatility and uncertainty stemming from President Trump’s tariff announcements have taken market participants on a roller-coaster-like journey. Equity markets experienced some of their biggest moves in decades, with the S&P 500 dropping by over 10% in the two days after the initial tariff announcement. Credit hasn’t been immune to the recent volatility but has done its job and held in well versus equities: it’s in these uncertain times that investors can take particular comfort in the fact that credit returns are contractual – based on company survival rather than business excellence. (See Figure 8.)

Looking ahead however, tariffs – or simply the uncertainty surrounding their implementation – could have a significant effect on credit markets, creating both risks and opportunities. Though President Trump appears to have softened his tariff measures, the overall tariff rate remains considerably above its 2024 level. And crucially, this episode has left the policy environment more challenging, geopolitical tensions – between the U.S. and China especially – appear elevated, and market participants lack clarity on the direction of fiscal and monetary policy.

The future is always uncertain but even more so now. What will happen when the current pause on tariff implementation elapses? How will negotiations between the U.S. and China progress? Will equity markets recover their lost ground in the coming weeks – or fall even further? Will Fed policy change? We don’t know, nor do we believe anyone does.

Figure 8: Credit Has Been Relatively Steady Amid the Volatility

Source: Bloomberg, as of April 17, 2025

(2) The Market’s Riskiest Names Feel the Volatility

After the significant drawdown in 2022, the highest-risk credits have consistently outperformed.⁹ As fears of a hard landing dissipated, buyers of CCC-rated bonds have generally enjoyed healthy price appreciation. (See Figure 9.) However, the recent bout of volatility led to a repricing of risk: CCC-rated bonds were trading within a 700-bps spread in February but blew out to 1,100 bps at the start of April.¹⁰ CCCs had led the market for two years but a shift in the economic outlook left many of the weaker names undesirable.

Though it’s worth noting that CCCs don’t make up a significant portion of the high yield market: indeed, over half the market is rated BB, which helps the market remain resilient amid the volatility.¹¹

Figure 9: Rating Performance Inverts

Source: ICE, as of April 22, 2025

(3) A Change of Course in Europe

European equities lagged the U.S. by significant margins in 2023 and 2024, with that relationship inverting so far in 2025.¹² While the S&P 500 remains negative year-to-date, the STOXX Europe 600 is marginally positive, with German equities a notable bright spot.¹³ Germany’s reform of its debt brake was particularly notable, paving the way for a historic increase in defense and infrastructure spending.

Accordingly, the yield on the ten-year German Bund increased by 30 bps in one day, the largest single-day increase in decades. (See Figure 10.) This then unwound as investors bought up German bonds amid the tariff tumult in the U.S., seeing the Bund as an alternative haven amid volatility. Away from sovereign bonds, investors in European corporate bonds must assess the benefits and risks to their holdings from a potential new economic paradigm, including increasing government spending, the impact of potential tariffs, and ongoing geopolitical volatility.

Figure 10: German Bond Yields Spiked Amid a Seismic Policy Shift

Source: Trading Economics