In a tight spot?

As the economic cycle turns, how is this affecting private credit markets?

For the past several years, the private credit market has operated in a largely borrower-friendly environment, with terms and pricing significantly favouring companies. Today, inflation, rising interest rates and economic uncertainty are all creating conditions that should push the pendulum much further in lenders’ direction, yet liquidity in private credit remains high relative to the last time we saw a more challenging macroeconomic backdrop. At the end of Q2 2022, dry powder in the market stood at US$412.9 billion, versus just US$104 billion at the end of December 2009, according to Preqin figures. How will these forces play out over the coming period?

There certainly seems to be plenty of optimism among private credit investors.“We’re in a changing time in the market,” says a junior credit manager at an insurance company. “It may even be the best time for new investments. Leverage is down and structured equity and mezzanine have become more attractive. Pricing has increased and the spreads are more attractive for investors.”

Scott Baskind, CIO and Head of Private Credit at Invesco, agrees that the conditions are ripe for strong investment opportunities in private credit. “As a lender putting capital to work, we’re seeing tighter structures, lower leverage and greater visibility of returns in this vintage,” he says. “Many companies are also demonstrating an ability to manage their margins in an inflationary environment. The risks today are emerging, have emerged or are known on a go-forward basis, which means we can develop new capital structures accordingly. When we combine this with the strong yield environment, we believe private credit investors are in a tremendous space.”

Indeed, Baskind adds, it’s an investment market that private debt players have not seen for some time. “We’ve seen strong deployment and solid returns over the past eight or so years, but the risk-return opportunity today is different and more robust. The potential for higher returns is greater and, when combined with more conservative capital structures, that’s what we get really excited about.”

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The risks today are emerging, have emerged or are known on a go-forward basis, which means we can develop new capital structures accordingly.

Scott Baskind, CIO and Head of Private Credit at Invesco

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A shifting tone

It may also mean a shift in the types of businesses that some funds target, as Brendan Carroll, Senior Partner and Co-Founder of Victory Park Capital, explains. “As interest rates increase along with available returns in public fixed income markets, the spread between public and private debt narrows,” he says. “Other private debt funds may need to generate a higher return than a year ago and will likely need to adjust the types of deals that they do, because LPs can find similar returns in the public markets with more liquidity.”

Sponsors, meanwhile, are seeking more flexibility from their lenders – and that generally means higher pricing and more attractive structuring for private debt funds. “At the beginning of 2021, the unitranche market was really hot and market participants were writing large tranches of 6.5-7x leverage, which made junior lending tougher,” says the junior credit manager. “Today, sponsors have a different focus. They are seeking capital in a structure that’s appropriate to a different environment. They are looking for flexibility – and that means mezzanine, preferred and structured equity, and PIK and holdco notes are all back. Sponsors are looking for multiple solutions and picking the right option for each business.”

The mood music in private markets has clearly changed as economic conditions have turned and interest rates and inflation have started to bite. Private credit investors and private equity sponsors are changing their underwriting assumptions about portfolio companies’ future performance.

For private credit, this means structuring deals for a much more challenging environment than the one we’ve seen for some years. “We are going into a period of economic weakness,” says Jeff Abrams, CIO Asset Management at ORIX Corporation USA. “The question is: how deep could a recession be? We always underwrite to a recessionary thesis, but we’ve applied deeper recessionary scenarios to our more recent investments.”

A challenging picture

Yet what the changed economic environment means for existing portfolio companies has yet to play out. The cycle has certainly turned quickly. “There has been an incredibly rapid decline in business performance because of inflationary pressures, labour shortages and energy price rises – and these are all impacting margins,” says Baskind. “The lower quality end of the market is much more challenged than before. We did see a dramatic sell-off and distress as a result of Covid a couple of years ago, but that was specific to travel and leisure businesses. Today, the shock is much broader.”

He adds: “Successful companies are able to pass through rising costs; the more challenged businesses can’t and they are seeing their leverage increase significantly as a result. For new deals, maintenance covenants are coming back and the single most important factor is ensuring that the expectations for future cash flows match balanced sheet health. This is difficult to fix in existing portfolio companies, however.”

All of which begs the question of whether we will finally start to see the distressed transactions typical of such an environment. “Ten to 15 years ago, you’d have periods where markets would sell off and asset prices would continue to drop,” says Abrams. “That created real distressed opportunities. Today, we’ll see – it depends on how bad the macro picture gets. There is a tremendous amount of liquidity waiting on the sidelines, so that even though we’ve seen pricing in the leverage loan market fall (from around 99 in January 2022 to 92 in July), it’s more at stressed levels than distress. I believe the liquidity may put a floor on the pricing.”

And that liquidity shows no sign of drying up any time soon. The inflation-resistant nature of private debt that stems from predominantly floating rate pricing in direct lending means that LPs are eyeing further allocations to this part of the private markets. Preqin, for example, forecasts an annual increase in AUM here of 10.8%. And North America-focused funds may well be a major beneficiary because of the strength of the US dollar and the fact that it is the “foremost reserve currency”, says Preqin. It adds: International investors are expected to flock to North America for private debt opportunities.”

Overall, the next 12 to 24 months looks set to be an active and interesting time for a variety of private credit strategies, with North America’s deep market a particular draw for LPs. This biggest question mark, however, is whether distressed opportunities really do start to come through.