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, central banks across the world have 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.
Some seasoned credit investors are on the side lines, 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
As central banks withdraw liquidity from the 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, and in pivoting from a world of abundance to one of scarcity, credit markets are struggling to adjust.
Direct lenders built up record levels of dry powder over the past five years, but they have also been busy putting it to work. Now, experienced managers are becoming more judicious about deploying the capacity they have left, for three reasons:
- Continued public market volatility and concerns around a slowing economy.
- The dislocation in broadly syndicated loans has compelled issuers to pivot to private markets for credit solutions.
- While recession worries may slow M&A, 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 opportunities 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 during the pandemic.
Future deals with tighter coverage ratios will also be scrutinised carefully. A world with a Secured Overnight Financing Rate above 4 percent isn’t as conducive to mega-cov-lite unitranches with leverage over 7x. In fact, cyclical sectors, or businesses with high capex, are less likely to make the cut.
Meanwhile, the amount of private credit dry powder is greater than ever, but it remains dwarfed by the money raised by PE sponsors. However, 2022 data suggests that sponsors may find a more challenging fundraising environment over the next several years.
It’s a similar story with deal activity. Certainly, a real recession will hurt purchase price multiples, but given their lofty levels, that might be welcomed by PE buyers. However, beyond better pricing and terms, hold levels are down and underwriting commitments off sharply. So, without more visibility on inflation, rates and the economy, GPs are reluctant to get stuck if market conditions worsen.
In this period of uncertainty, with managers carefully weighing up risks versus opportunities, does it make sense to wait for more direction from the economy? At Churchill, we believe the answer lies in the role of the manager in an illiquid asset class.
With illiquid assets, selection is key
For private equity and credit, portfolio construction is key. The importance of picking the right assets from the start largely determines returns and, since you can’t trade the assets, you can’t easily unload a problem into a ready secondaries 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-favour industries. Liquidity allows them to pick exit and entrance points, but if a consumer-facing borrower or a heavily cyclical business stumbles when the economy softens, a buy-and-hold lender may find themselves with a long-term problem.
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 now for private credit investors is: can you be rewarded while managing today’s level of greater risk? The current credit vintage, which sports lower leverage, tighter structures and wider pricing, is significantly more investor-friendly than anything over the past decade. Not since 2010 have we seen near 10 percent yields for traditional mid-market senior debt. But issuers who don’t need to face the debt market could elect to wait until conditions ease.
However, we expect to see direct loan activity slowing. After all, most private capital managers 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. Velocity of investing and realisations 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, and they maintain healthy all-weather pipelines.
Put this together and the upper hand lies with experienced private credit managers who know that a large, diversified client base and deal portfolio keep dealflow coming regardless of buying sentiment, and allow investors to benefit from uninterrupted deployment and allocations. These managers will also enjoy the better yields and structures being obtained in the current market.
Nevertheless, the next several quarters will be constructive for private credit investors. Scarce assets are more highly valued, so 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.