Looking ahead: U.S. private credit in an age of scarcity

For over a decade, including through COVID-19, the tide of capital has flowed mostly in one direction: into markets. That’s because since the Great Recession of 2008, the U.S. Federal Reserve has kept interest rates low. Public credit, both loans and bonds, benefited from this support. But as we look ahead to 2023, it is important to shift our gaze and examine the impact of rate hikes and quantitative tightening on capital markets and private credit.

Factors shaping private credit in 2023

• As new public credit issuance stalls, private credit is attracting larger and higher quality financings.
• With additional demand on their dry powder and looming cyclical risks, private lenders are even more selective about the opportunities they take on.
• Economic uncertainty is slowing M&A activity, but managers with the best proprietary deal flow will source better relative quality and volumes.
• Through all cycles the most experienced private credit managers can extract attractive investor terms and maintain a low-default, diversified portfolio.
• In a time of scarcity, managers with a full suite of private capital solutions and deep sponsor relationships in defensive sectors will rise to the top of preferred lender lists.

Private capital, particularly credit, benefited in the last decade from a near-zero rate environment. Investors sought investments with premium yields to liquid credit while still retaining low risk. Private equity sponsors obliged by working closely with their direct lenders to put their own LP money to work with a burgeoning pipeline of buyout financings.

From a credit perspective, structures and pricing became increasingly issuer-friendly as arrangers competed for lead deals. These erosions were rationalized because elevated purchase price multiples provided greater cash equity cushions below the debt.

COVID-19 threatened to upend this momentum, but the Fed’s loose money intervention quickly restored it. That liquidity rescue, combined with continued supply chain challenges, created unusual upward pressures on inflation, resulting in headline consumer pricing levels not seen in decades.

The persistence of high consumer prices, has forced the Fed into more hawkish messaging. Investors have translated this to greater recession and default risk. Retail cash departed both bond and loan mutual funds in 2022 on a massive scale, reversing in the broadly syndicated loan market what ha begun as a positive response to higher floating rates. That plus recession worries have shut down high-yield issuance.

Thanks to Fed tightening, liquidity is also retreating from the banking system. Bank reserves are projected to be drawn down by a third, from $3 trillion, to $2 trillion in the first quarter of 2023. Some bankers say they have been told to restrict their corporate and wholesale lending.

We’ve reported for years how the broadly syndicated lending market is being disintermediated by the largest direct lenders. But as overnight lending rates soar from near zero a year ago to nearly 4% projected by year end 2022, those lenders are seeing shrinking interest coverage ratios on highly leveraged deals.

Naturally this is all sobering news. Some seasoned credit investors are on the sidelines, waiting for more direction from markets and the economy. Our reappraisal of current conditions, however, suggests there may be a lot for investors to cheer about, particularly in private credit.

In fact, we believe that capital scarcity is ultimately beneficial for illiquid loans.

Risk vs. Opportunity in private credit

Supply chain issues aren’t limited to bikes and baby formula. As the Fed withdraws liquidity from the banking system and investor cash exits public credit, it’s more challenging to deliver capital to businesses seeking funds for traditional buyouts and M&A activity.

In pivoting from a world of abundance to one of scarcity, credit markets are struggling to adjust. Direct lenders have built up record levels of dry powder over the past five years, but they have also been busy putting it to work. For several reasons, experienced managers are becoming more judicious about deploying the capacity they have left.

A balancing act:

• First, credit fund investors are more cautious about new allocations, thanks to public market volatility and concerns around a slowing economy. Ironically, the better the yield prospects for floating rate assets in a rising Secured Overnight Financing Rate (SOFR) environment, the more tempting to wait for even better returns down the road.
• The dislocation in broadly syndicated loans has also compelled issuers to pivot to private markets for credit solutions. An estimated $1 trillion of capital is invested in private credit today, but the amount of dry powder is less.
• While recession worries may slow M&A between now and the end of the year, pent-up demand from private equity sponsors flush with LP cash will drive flow once conditions allow.

Top private credit managers are increasingly weighing risk versus opportunity in allocating capital to deals. The opportunities are seen through the lens of a possible recession that could upend earnings and valuations of companies that have performed well, even through the pandemic.

Future deals with tighter coverage ratios will also be scrutinized carefully. A 4% SOFR world isn’t as conducive to mega cov-lite unitranches with leverage over seven times. Cyclical sectors, or businesses with high capex, are less likely to make the cut.

Finally, while the amount of private credit dry powder is greater than ever, it remains dwarfed by the money raised by private equity sponsors. Will sponsors find a more challenging fundraising environment over the next several years? 2022 data seem to suggest as much.

Similarly, with deal activity. Certainly, a real recession will hurt purchase price multiples, but given their lofty levels, that might be welcomed by PE buyers.

How is manager selectivity manifesting itself? Beyond better pricing and terms, hold levels are down and underwriting commitments off sharply. Without more visibility on inflation, rates, and the economy, GPs are reluctant to get stuck if market conditions worsen.

Private capital amid public capital scarcity

In a world where cash is either being withdrawn systemically through quantitative tightening or selectively by investor caution, capital formation is being challenged.

Public capital utilization is governed by fast cash, so when money flows out of retail funds at the pace it has, it’s a headwind to deal activity. Private capital has long-term, locked-up funds. But in this period of uncertainty, managers are also carefully weighing risk versus opportunity. Does it make sense to wait for more direction from the economy?

With illiquid assets, selection is key

The answer lies in the role of the manager in an illiquid asset class. For private equity and credit, portfolio construction is key. The importance of picking the right assets from the start largely determines returns. Since you can’t trade the assets, you can’t unload a problem into a ready secondary market.

Asset and sector selection also matter across business cycles. Timing is a part of every public market portfolio manager’s tool kit to seek undervalued loans or out-of-favor industries. Liquidity allows them to pick exit and entrance points. But if a consumer-facing borrower or a heavy cyclical stumbles when the economy softens, a buy-and-hold lender may find themselves with a long-term problem.

In a world of greater selectivity, relationships matter

Managers are also coming under greater scrutiny from credit investors. Issues such as differentiated sourcing, always part of standard diligence, are taking on increased importance in a world of deal scarcity.

The key to sponsor-focused lending is relationships. Today it’s not only who you know, but who trusts you to deliver. The impact of compressed interest coverage ratios and the risk of recession has caused lenders to more carefully allocate their remaining dry powder. That has dramatically reduced hold levels, not to mention forward underwriting commitments.

Sponsors are adapting by clubbing more transactions among a smaller group of trusted relationship players, rather than relying on one lead for the entire piece.

The prospect of a pause in M&A activity has compelled sponsors to look to existing platforms for growth. Lending groups are accordingly fielding more add-on financing requests. They are also being asked with each deal, how much more dry powder do you have?

Higher all-in borrower costs are also pressuring PE firms to push the envelope on most favored nation clauses. These credit agreement covenants protect lenders from issuers obtaining new debt on more favorable (e.g., higher spread) terms without treating existing lenders to the same terms, subject to certain baskets.

Another tactic is to expand delayed draw term loans to fund acquisitions. As rates escalate, locking in today’s spreads will no doubt be cheaper than waiting for whatever tomorrow may bring.

Private credit trends so far

The world is changing from one where risk-taking was rewarded, to one where it is punished if not appropriately managed. The question for private credit investors is, can you be rewarded while managing today’s level of greater risk?

In a nutshell, the Fed’s withdrawal of systemic capital and relentless rate hikes plus the flight of cash from liquid credit has opened a window of opportunity. Yet higher yields will drive up default rates based on tighter ability of issuers to meet interest payments. Squeezing capital supply and spending could then trigger an economic slump.

Supply slowing

Ironically, the current credit vintage, which sports lower leverage, tighter structures, and wider pricing, is significantly more investor-friendly than anything over the last decade. Not since 2010 have we seen near 10% yields for traditional middle market senior debt. But issuers who don’t need to face the debt market could elect to wait until conditions ease.

We expect to see direct loan activity slowing. After all, most private capital managers have enjoyed a strong 2022 run. No one feels like stretching when there’s so little visibility on earnings and inflation, let alone continued supply-chain bottlenecks and geopolitical uncertainty.

Much depends on how PE firms play the current environment. As the following chart shows, velocity of investing and realizations have also contracted. Some buyers are pencils down, believing market multiples will retreat, improving investment opportunities down the road. Others have long developed conviction around M&A strategies with select businesses expected to perform through every business cycle. They maintain healthy all weather pipelines.

Experienced private credit managers have seen this movie before. A large, diversified client base and deal portfolio keep deal flow coming regardless of buying sentiment, and allow investors to benefit from uninterrupted deployment and allocations. It also means they will enjoy the better yields and structures being obtained in the current market.

With rates and spreads on the upswing, refinancing activity has slowed markedly. Fewer repayments suppress lender dry powder – not necessarily a bad thing. Add-on financings are up as sponsors seek ways to build existing platforms in lieu of new buyouts.

The average hold period for direct loans of two to three years should accordingly lengthen. What are the implications of that trend? Duration risk is still modest compared with fixed income. But moving the needle on average yields and leverage in a large, diversified portfolio takes time. It also becomes tougher to trade into other strategies, sectors, or assets.

Nevertheless, for private credit investors the next several quarters will be constructive. Scarce assets are more highly valued. The question is, as the era of greater selectivity unfolds, will there be enough to go around? For lenders with strong sponsor relationships and unique sourcing models, we believe so.