Fear of the unknown – but excitement also

Challenging market conditions mean Europe’s private debt firms are cautious, while expressing confidence in the current vintage.

“This is more like the 1970s which means we’ve not seen this movie before, since leveraged credit was born in the 1980s,” said one delegate among record numbers of attendees as this week’s Private Debt Investor Europe Summit in London. With interest rates poised to stay “higher for longer”, asset class professionals found themselves reflecting on an unprecedented situation. “We’re only at the very beginning of figuring out this transformation,” said one panellist.

It wasn’t hard to find those willing to admit that Europe finds itself in a very difficult situation, and unsurprisingly distressed and special situations investors are taking a keen interest. The extent of distress will be naturally linked to how high rates go. One view was that, when rates reach 6-7 percent, you start to get “broad-based financial distress” in the face of reduced earnings and interest coverage ratios coming under pressure.

At that kind of interest rate level, default rates are expected to be around 10-12 percent. That’s quite a change from the 2 percent more typically seen in recent years and might be expected to unsettle LPs. That sense of unease could be exacerbated if the link to lack of investor protection in the documentation of deals completed over the past few years becomes a clearly established one.

Nor is there expected to be any significant backstop this time either, unlike during the early days of the covid pandemic when governments offered support to companies on an unprecedented scale. Some say, incidentally, that this is a good thing as state intervention caused bad habits to creep in and glossed over weaknesses. This time, it will be easier to judge the strengths and weaknesses of management teams and deal documentation.

But for all the concern, the opinion was voiced on more than one occasion that the current vintage could prove to be one of the best for new investments – and almost certainly the best since the aftermath of the global financial crisis. Aside from stressed opportunities, other areas cited included hung bridge loans, large deals coming to private debt instead of the public markets, secondary deals and non-sponsored transactions given what is perceived to be a weakening of banks’ commitment in this area.

On a relative basis, debt perceives itself to be in a strong position. As one panellist drily noted: “It’s a scary time to be an equity investor right now; it’s a lot better to be a lender.”

Write to the author at andy.t@peimedia.com