Private credit will create an interesting set of winners and losers in private debt markets. Borrowers will have a more difficult time due to an increasingly challenging macroeconomic environment, but such a landscape might provide private debt managers with more bargaining power than in years past.
Difficulty for some, advantage for others and overall resilience
2022 was a difficult year for private credit borrowers. A series of historic interest rate hikes, unrelenting inflation and geopolitical tensions have all contributed to significant headwinds for those looking to borrow in the private credit space. This led to higher competition for deals, lenders deploying loans with fewer stipulations in order to secure business and tight spreads to public debt.
Despite this, investors continued making investments and renewing with their managers given the lackluster yields available elsewhere. The private lending space in fact has shown signs of resilience, and how it is built for supplying corporate borrowers with needed finance in rising rate and turbulent market conditions.
As we move further into 2023, the private debt picture looks different, and shows signs of resilience if not for borrowers needing to hang tight perhaps for a couple quarters more. An important shift, 2023 thus far has shown that lenders have greater influence in securing stronger loan covenants than years past. When money was easy and competition high, private lenders had less power in negotiating terms of their loans. This led to loans with fewer restrictions and newer, less-experienced market entrants. Now, a reversal is underway and lenders are able to secure better terms.
Adding another layer to lender strength was the tremendous pullback in traditional bank middle market liquidity. Major banks saw around $40 billion of incomplete deals on their balance sheets in 2022, and the meltdown of Silicon Valley Bank made middle market lenders even more skittish.
This has created the ideal mix of factors that gives the upper hand back to private lenders. Smaller delayed draw term loans, maintenance requirements and enhanced call protections are now back in a lender’s loan arsenal.
Low default risk
Private debt has seen markdowns, as the private markets lag public market markdowns in valuations, but overall the asset class remains healthy and outside of default territory. Interest coverage ratios sit well-above 1.0x, indicating a significant fallback cushion to avoid a default should rates rise further and EBITDA ratios decline.
Managers can emphasize the value-add
One flaw in the private credit space made obvious during recent turbulent markets is the need for highly-skilled management teams in the event of worsening macro conditions and increased risk of default. A considerable amount of private debt investments were made during favorable market conditions without realistic downturn scenarios built in. Higher competition led to lax covenant deals and high demand led to inexperienced market entrants.
Now with the risk of recession looming in a very real way, it highlights the need for experienced managers to mitigate the possible fallout.
Previous high yield default cycles peaked at 12 percent on average following recessions1, which means underwriting discipline is a non-negotiable in the face of potential recession. Importantly though, market downturns also provide experienced private debt managers with an immeasurable opportunity.
Should defaults rise and the economy enter a recessionary period (be it light or longer-lived) clients will rush to skilled and experienced managers to get deals done or add them to deals in an attempt to save poorly-pieced-together loans agreed upon in easier money times. Direct lending funds with experienced personnel to work out these problems that also maintain high recovery rates will be able to better weather the credit storm, but will also re-position the value-add that many active managers combat.
This puts managers in a position to demonstrate true value-add to their clients and future loan agreements. Perhaps this period of stressed private credit borrowing will prove to clients that experienced, well-structured loans with fair covenants will benefit them longer-term, and the most efficient use of that relationship is with an experienced lending manager.
There is opportunity in “good company, bad balance sheet”
Overall market instability has stressed a number of companies that made some mismatched investments during easier monetary periods. Special situation investing is a strategy pursued by some investors seeking to profit from distressed or urgent needs of financing in order to stay afloat. The special situations investor expects to eventually profit from the loan as the underlying company rebounds following financial help.
Today, higher costs of capital and stricter financial conditions have the potential to stress good value companies. Good businesses that perhaps made a mistake or were already in a tenuous position that simply needed minimal financing to recover were especially exposed during the last year.
This presents an interesting opportunity for special situation investors. There are numerous companies on the market today that go by the old adage “good company, bad balance sheet” that are ripe for private credit market investors. These companies hold fundamental value but might have accounting errors or a couple of bad investments on their hands. The problems might be easily remedied with an infusion of capital, but the company itself isn’t able to rebound on their own. Oftentimes, the situation is as simple as improving cash flows or reducing leverage.
Further, the risk/reward in this market can provide special situation investors with portfolios of uncorrelated investments that at their core might present good value but due to market conditions are trading at a deep discount. The best investments in this category will be companies poised to perform during recessionary and inflationary periods and were successful before, but happened to fall victim to the same turbulence others did over the past 18 months. These investments will allow for lower prices and attachment points, potentially leading to greater margin for the private debt investor who chooses them wisely.
The private credit markets are in a transformational period, but overall remain robust enough to survive the evolution of the next anticipated market downturn/recessionary period. Investor interest is still strong, and lending managers are able to simultaneously have the upper hand in negotiations and demonstrate much needed value propositions as investors look to navigate default risks and high interest rates.
1 Based on S&P speculative grade index historical default rates and NBER recessions going back to 1982.
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