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 fundraising.

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 US$1.70 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 favour. 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, the lead portfolio manager for global private debt at Allianz Global Investors. He prefers to invest in private credit without leverage.

  - Bloomberg