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There’s Good News in Direct Credit
Demand remains strong in the U.S. economy, and that spells opportunity in private credit.
When the general conversation in the investment world was still centered on whether inflation might be transitory the team at Antares Capital made its decision. Long before the war in Ukraine, the team realized geopolitics could amplify an inflationary scenario.
“We were focused on inflation in the October timeframe, well ahead of the Fed acknowledging that it was not transient and that it was really something more problematic,” says Tyler Lindblad, Chief Investment Officer, Antares Capital. “And our view is that the current geopolitical situation will exacerbate inflationary pressure.”
That said, all the news around inflation is not bad, according to Lindblad.
“Demand in the U.S. economy continues to grow,” he says. “It’s very strong, particularly among the types of middle market companies we favor. Even if there is modest margin decline that causes EBITDA to fall a bit, the risk of that’s going to be absorbed by the equity and there may be a slight impact on returns. From where we sit, however, it doesn’t pose any real issue from a debt principal risk perspective.”
U.S. economy is well-positioned, and sponsors are ready to respond to change
It is possible that demand could slow as interest rate hikes and increased inflation drive the Fed toward more hawkish behavior. But Lindblad is careful to note that context matters a great deal in the current environment.
“The U.S. economy is still well positioned in 2022 and into 2023,” says Lindblad. “Clearly, the risk of some sort of recession or stagflation has increased, and the Fed must walk a tightrope, which makes their job a little bit more difficult. It’s certainly something we’re paying attention to – but it’s quite important to realize that by historical standards interest rates are still very, very low.
“Even after the projected increases that we see coming, you’re still looking at a LIBOR or a SOFR index that’s in the 2.5-3% range, which is still very attractive relative to historical standards,” Lindblad adds.
Lindblad expects demand to remain high in the U.S. economy, as evidenced by enterprise values being high and sponsors putting significant amounts of money to work in the middle market.
“In the handful of situations where interest rates rise and a company doesn’t perform as well, it can cause potential liquidity issues – but we believe the private equity sponsor is going to be there to support the company,” says Lindblad. “We saw sponsors step up during Covid, and our expectation would be is for more of the same going forward.”
Modest dislocation is a good thing
Amidst rising rates, leverage will remain a key tool for private equity firms to make their returns. “Private equity firms have raised a record amount of capital, and we think they are going to deploy it,” says Doug Cannaliato, Senior Managing Director, Sponsor Coverage for Originations, Antares. “While leverage may be a bit more expensive than it has been in recent years, we don’t expect its importance to private equity firms to change in this environment.”
With volume and deal activity expected to remain robust in Antares’ view, what might a bump in volatility mean for pricing?
“Pricing has remained relatively stable," says Cannaliato. "There has been an increase of about 50 basis points in the syndicated market. In the direct market, which already gets a premium over the syndicated market, pricing has been very stable.”
On the original issue discount (OID) side broadly syndicated loans have seen modest increases to OID. “Where they were used to getting maybe 99 [cents per dollar] it briefly moved to 97,” says Cannaliato. “And it has already crept back to 98. And on the direct market OID remains stable at about 2%.”
Lindblad agrees that volatility in the loan market has been very modest relative to other asset classes largely due to its secure and conservative nature. In fact, says Lindblad, as is the case with modest inflation, the news isn’t all bad with some increase in volatility.
“When there is some modest dislocation it’s actually a very good thing for middle market companies because it makes direct credit even more attractive to sponsors,” says Lindblad.
“When we think about the fundamental growth drivers of direct credit, we look at favorable equity and returns that enable significant sponsor capital to be raised for financing,” says Lindblad. “In the disintermediation that’s taking place we’re seeing a move from the public market to the direct credit market, and it enables us to invest additional dollars. Couple that with the incumbency advantage within our portfolio and it gives us very attractive ways to deploy capital.”