The lessons learnt in private credit
The measures put in place to contain COVID-19 came - to put it mildly - as a bit of a shock to investors around the world. While many had been awaiting a turning of the credit cycle for some time, few would have predicted an imminent health crisis and the type of dislocation it might create.
While 2020 was an extraordinary year in so many ways, there are lessons to draw from what happened. Most businesses, for example, have been working through how they can best build resilience to ensure they can survive and thrive through future unforeseen events, and private credit managers are no exception. But how has the pandemic affected the way in which LPs think about, and approach, their private credit exposure?
One of the biggest surprises of 2020 has to be the market’s rebound from the end of the second quarter onwards, especially as there have been so many relatively recent entrants to the space. “Private credit markets seem to be back to normal,” says Marcel Schindler, Partner and CEO of Private Debt at StepStone. “They have demonstrated resiliency. Many feared the success of private debt through the GFC wouldn’t be repeated this time around, in particular as there were so many new managers in the market that hadn’t been through a cycle.”
A major lesson for many LPs from this has been the importance of taking a flexible and diversified approach to credit, which can span a range of situations, including liquid and illiquid strategies. This can mitigate risk and offer LPs or their credit fund managers the chance to take advantage of dislocations as they appear in the market, especially as some of these can prove relatively short-lived.
“We deployed approximately gross C$6 billion in the Americas within corporate credit during the pandemic, split between high yield and credit opportunities,” says David Colla, Managing Director and Head of Americas Leveraged Finance at CPP Investments. “We didn’t see huge opportunity in private special situations because so many companies had access to capital through the liquid credit markets as well as sponsor support. Early on in the pandemic, we couldn’t play much in private markets and so we pivoted to investing in what was an attractive high-yield credit market. From July onwards, though, there was a ton of opportunity in direct lending derived from buy-outs, especially in the tech-enabled space.”
Having capital ready to deploy through more turbulent times is another lesson to draw from the experience of the pandemic, given that these periods can offer strong returns potential. “We have a balanced program spanning liquid, illiquid, public, private, niche, smaller larger and so on,” explains Wesley Pulisic, Head of Alternative Credit at NYC Comptroller. “We had a good amount of dry powder and we had $600m of capital calls in the few weeks of March and through April. We were prepared for volatility, but we got lucky in some respects because we had sufficient dry powder and we even had one of our manager’s portfolio companies get bought out by a SPAC.”
And for many, COVID-19 emphasized the value of relationships, particularly with private equity firms in sponsored deals, as lenders, equity providers and managers pulled together to help businesses through some extremely challenging conditions. “Across the private equity industry – senior lenders, junior lenders and private equity – people largely reacted in the same, rational manner and were amenable to finding a way through the pandemic,” says Jeff Behring, Director of Private Debt and Equity at Northwestern Mutual Capital. “We saw some businesses experience temporary declines in demand, but they typically received the support they needed from lenders and equity investors, and they have come back. Private credit was a great place to be invested through the pandemic.”
It’s a point also picked up by Pulisic. “We saw nimble managers with the ability to rotate or to deploy dry powder performing better,” he says. “We also look for managers with solid underwriting capability and strong relationships with sponsors. This allowed them to negotiate successfully and move borrowers forward.”
Indeed, private credit appears to have weathered the storm of the past year or so pretty well, with many LPs now more keen on the asset class than before and with stronger relationships forged with others in the funding ecosystem as a result of having to work together through the crisis. “Private credit performed incredibly well, given the circumstances,” says Ryan Morse, Director of Alternative Investments, Pennsylvania State Employees’ Retirement System. “We’re now more confident today in the asset class than we were before. It was the industry’s first real test in a long time outside of specific sectors, such as oil, and we found that managers had already tilted portfolios towards resilient businesses before the pandemic struck.”
Morse adds that the pandemic has validated the plan’s focus on sponsor-backed strategies. “We’ve always preferred sponsored situations and COVID-19 solidified this for us,” he says. “Private equity houses were generally willing to support companies with capital and expertise – that is one of the reasons we came out of the pandemic with a strong portfolio.”
So what should investors carry forward, given the experience of the past year and the current environment, beyond keeping powder dry, pursuing a range of strategies and valuing relationships? One area for close consideration, given the rise of direct investment strategies in private markets more generally, is whether to back funds or to build in-house teams. Behring’s organization, Northwestern Mutual Capital, has opted mainly for direct investing. Yet this is not an easy path. “To be successful, you need an organization that has a full infrastructure of an established asset manager to source a wide array of investment opportunities from which to choose and successfully manage through economic cycles,” he advises.
Colla is also circumspect, given the low interest rate environment that continues to persist post-pandemic. “Returns may be down, given where interest rates are,” he says. “CLO equity can present a unique way to mitigate rate risk,
though you need to be very mindful of the levered credit risk taken. It’s a competitive space, but there are incumbents in middle market direct lending, as well as the broadly syndicated loan market, that have proven track records through multiple cycles in creating strong CLO equity returns.”
And, while there will be plenty of opportunities over the coming period, including in areas such as rescue finance as government support initiatives start to be withdrawn, the market resilience we see may be more superficial than we might think, particularly given the rapid rebound in activity, high levels of liquidity in the market
rebound in activity, high levels of liquidity in the market and the move back towards pre-COVID-19 terms. Successful investing in such an environment will require some caution, rigorous analysis and strategic deployment of capital.
“Direct lending markets have proven their resilience and, combined with their attractiveness relative to public markets, have attracted significant investor capital,” says Schindler. “The crisis and second-order effects are not always digested and therefore priced into the market. Below the surface, not all is back to normality so investors will need to carefully evaluate their investment approach.”
So what is his advice for investors? “We recommend strategic and not tactical allocation to the space,” he says. “LPs need sufficient diversification and the bottom-up expertise of experienced GPs may be combined with co-investments and secondaries to unlock relative value that private debt and direct lending can offer.”
