Resiliency across cycles
By design, private credit is positioned to maintain resiliency through both recessionary and rising rate environments.
In a recessionary environment, private credit has the benefit of being senior within a borrower’s capital structure and having directly negotiated credit agreements that offer tighter terms and superior covenant protections. In addition, private credit investors often have hands-on monitoring and portfolio management capabilities that tend to be more partnership-oriented in supporting borrowers through periods of credit and business dislocation. Private equity sponsorship further provides additional dry powder to support the business as well as guidance to management on how best to navigate choppy economic waters.
During rising rate environments, private credit directly benefits from an increasing base rate given its focus on floating-rate debt securities, which typically resets every one, three, or six months at the higher market rate. Today’s period of volatility and dislocation has also introduced higher spreads and higher original issue discounts (lower prices), which accrue on top of the higher base rate and typical illiquidity premium, resulting in compelling absolute returns for the asset class.
Opportunity in volatility
Rising interest rates, recessions fears, persistent inflation, and geopolitical risks have put the primary and secondary public leveraged loan and high yield bond markets under significant pricing pressure. Subsequently, banks are struggling to offload billions of dollars of hung deals that were committed to prior to the current period of volatility. Estimates of the magnitude of hung deals on bank balance sheets have been at $100 billion or higher.
Faced with several unpalatable options to cleanse their balance sheets, banks have been selling leveraged loans and high yield bonds at significant discounts, resulting in deep losses to their bottom line. While banks have been preoccupied with offloading their hung deals and sitting on the sidelines, private credit deal flow and origination volumes continued to hit record levels with the highest quarterly origination volume to date in 2Q 2022. Not only has private credit stepped in to directly finance transactions neglected by the public capital markets, private credit has also become an opportunistic buyer of the deeply discounted loans and bonds that banks have been desperately trying to sell.
Current market trends
Against this uncertain public market backdrop, terms for private credit investment opportunities have markedly shifted in favor of the lender. Private credit investors have witnessed lower leverage coupled with spreads increasing by 50-150 bps and OID widening by 100-200 bps on directly originated deals, on top of the increasing base rate driven by rising interest rates. Call protection has also improved, allowing private credit investors to benefit from these higher yields for a longer period of time. Credit agreement documentation terms have focused on further restricting the borrower’s ability to take on new debt or pay out dividends, which results in more cash available to service debt. This may mean tighter EBITDA definitions, more onerous financial maintenance and incurrence covenants, and limitations on restricted payments and related baskets.
Today’s volatile markets enable private credit managers to not only generate higher returns than before but also upgrade their portfolio’s credit quality while doing so. Capital structures and terms are improving for lenders not only in new issuances but also in add-on transactions supporting existing portfolio companies. Industries and companies are being scrutinized with less cyclical, recession resilient businesses being favored over more cyclical ones. Fewer dividend recapitalization transactions are being completed and unfunded DDTLs are decreasing in size and shortening in duration.
Hold sizes among many private credit lenders have also decreased, in some instances by more than half, driven in part by a slower fundraising environment. Smaller hold sizes have imbued additional investment discipline and rational behavior among private credit providers as the supply of private credit is being pulled back at the same time the demand for private credit is surging.
Private equity dry powder stands at record levels today, enabling private equity sponsors to continue to be active acquirers of businesses despite market volatility through sponsor-to-sponsor transactions, take-privates of publicly traded companies, and corporate carve-outs and divestitures. This record level of dry powder further secures a robust pipeline of opportunities for private credit to finance.
There have been many metaphors used to describe the public markets, all of which could have been used at times to describe what we have witnessed in 2022 alone: bulls, bears, dead cats, falling knives, and roller coasters. Nevertheless, in the world of private credit, these will be remembered as halcyon days.
Although private credit is not immune to supply chain challenges, inflationary burdens, slowing growth, rising rates, or other macroeconomic headwinds, it is much better equipped to withstand such pressures and deliver higher absolute and risk-adjusted returns than its investment alternatives.
Private credit managers have the ability to conduct disciplined, bottom-up credit underwriting with a focus on capital preservation, strong free cash flow generation, and robust debt service coverage. Private credit managers’ investment horizons are long, as they hold onto their privately originated loans and remain more insulated from public market price fluctuations. Structural seniority, stronger investor protections, tighter documentation, and proactive portfolio monitoring allow private credit to remain resilient in light of recessionary pressures while reaping the rewards of higher spreads and higher interest rates.
While today’s volatile markets are proving private credit’s value proposition of financing certainty to private equity sponsors and borrowers, the higher absolute and risk-adjusted returns being generated are validating private credit’s attractiveness to limited partners and other investors in the asset class.