Fidelity: Direct lenders steal market share in volatile environment

Debt funds set to benefit from strong risk-adjusted returns as terms move in their favour, says Michael Curtis, head of private credit strategies at Fidelity.

This article is sponsored by Fidelity

Michael Curtis
Michael Curtis

How has the private credit market responded to volatility in public markets, and have the correlations between public and private credit held true?

We have seen concerns across the market about inflation, which have accelerated since the outbreak of war in Ukraine. During the year there has been a significant increase in volatility and a much greater correlation between asset classes across the broader public markets.

As a result, we see private credit stepping in to provide capital and financing where public markets are not currently able to. Banks initially continued to compete fairly aggressively and actively underwrite new transactions but, as volatility persisted, the arranging market has struggled since April and private equity has relied much more on direct lenders.

The terms being offered by arranging banks that are still willing to put their balance sheets to work have also tightened, further driving private equity firms towards the private credit markets.

What does the persistent inflationary environment mean for direct lending?

The market is playing into the hands of the direct lenders. They have experienced less volatility because of the stable nature of their investor base and the seniority of their position in the capital structure. Many direct lenders have also had significant dry powder to put to work, and the rising rate environment allows the returns from direct lending to increase at a time when many other asset classes are experiencing the opposite, especially the fixed income markets. So, it has been a positive environment for direct lenders to gain market share.

A rising rate environment does put pressure on credit metrics for companies, however, and there are going to be companies impacted by inflation and unable to pass on input costs or who suffer from demand destruction. That will put pressure on the portfolios of direct lenders, and there will be situations that lenders are going to have to manage through. Direct lending is not immune from what is going on in the broader economy, but it remains a strong defensive asset class.

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How would you describe the current outlook on dealflow and the ability of managers to put capital to work? And how do you anticipate that changing going into 2023?

Dealflow has been pretty strong over the last few quarters because banks have been less aggressive in providing financing and direct lending has stepped up. Some of the dry powder raised in the last few years has been used up faster than anticipated as a result of that opportunity.

M&A was reasonably active in the first half of the year but is now slowing. The volatility in equity markets is a disincentive for companies that wanted to put themselves up for sale and strong, active companies are not coming to market if they don’t need to. We expect M&A to be down significantly for the rest of the year and probably until government bond markets stabilise. It usually takes three to six months for that to happen, and then we expect activity to start to come back.

Private equity funds have raised a lot of money and will be motivated to put that to work in 2023 and 2024, when we see significant opportunities for direct lenders to play a role in those financings. The next few years will ultimately be seen as some of the best vintages for direct lending because they will benefit from higher margins, better structuring and stronger documentation, which means risk adjusted returns look like they are going to be pretty favourable.

With the growth of the direct lending market, where do the opportunities lie for investors looking for exposure in the asset class?

There is less competition to provide financing from the capital markets right now and in markets like these, direct lenders are able to extract some of the best terms ever available. The ability to capture highly attractive risk-adjusted returns is extremely strong.

It is important to have the resources available for debt structuring, deep due diligence and broader research, in order to properly underwrite the risks across the different opportunities available today. Managers can do that knowing that inflation is a risk, which means they can factor that into due diligence and look closely at the ability of a company to pass on costs.

The ability for direct lenders to dig deeper with management teams and structure debt financings with lower leverage is an opportunity to capture more attractive risk-adjusted returns. Lenders can put the right security packages in place, with the right covenants, to ensure they are protected if performance is not what was expected.

Direct lenders should continue to be pricing at a premium versus the broadly syndicated markets. Given what has already been priced into levels today, in order to have a capital loss you would need to experience multiple times the default rates that occurred during the global financial crisis. If you think direct lending generally outperforms the broadly syndicated markets, and you put stronger structures in place to take account of the environment, it is a great and also defensive place for investors in this climate.

Why does the core mid-market offer attractive opportunities?

“The ability to capture highly attractive risk-adjusted returns is extremely strong”

While we think direct lending more broadly continues to be very attractive, we still think the middle market is where the best risk adjusted returns are to be found. That’s because in the true middle market, which to us means lending to corporates with EBITDA of between €5 million and €35 million, we see far less competition from banks, who are pulling back and taking longer to provide capital. Managers who can provide a pan-European lending strategy are appealing, and there are fewer direct lenders in that space so that is where the supply-demand equation is most favourable.

The experience of our sustainability team, which operates across the public markets and covers about 4,000 companies, also helps. We look to assist companies that we lend to and encourage them to drive sustainable change, and we think our ability to do that with more impact is greater in the middle market. There is also lower leverage, better documentation and higher pricing than there is in the larger cap space.

What should different investors in direct lending consider when assessing their credit allocations?

There is a lot of discussion about the US being more resilient to the upcoming recession than Europe, but by our analysis Europe currently offers higher pricing than the US, with average unitranche interest rate margins at 6.6 percent versus 5.8 percent. There are typically larger equity cushions in Europe, worth 47 percent compared to 43 percent for the US, and leverage is marginally lower at 5.1x in Europe versus 5.2x in the US. The industry segments that tend to be favoured by direct lenders in Europe have also typically been more defensive.

Direct lending offers investors much more stable returns over the longer term, with the benefit of floating rates. We are also about to hit even more challenging times for corporate fundamentals and being senior-secured in the capital structure is a great place for investors.

In a buy-and-hold environment, what will credit managers need to focus on in order to manage through volatility?

The European direct lending markets have historically been quite benign, with issues cropping up rarely and default rates are typically low. Managers have not really been tested.

“The market is playing into the hands of the direct lenders”

But, in our experience, there has been too much focus on deployment over making strong investments. We think managers need experience through multiple cycles and to be able to carry out thorough due diligence and stress test financial models for a variety of scenarios. That does not just mean different interest rate scenarios, but also different scenarios for demand destruction, which we think will be a theme in 2023.

At Fidelity, we have an extremely experienced team that has been through multiple cycles, and we have resourced the team with both distressed experience and workouts experience. It is important to use that workouts lens even when making new loans and to think through how different scenarios can play out.

We also have 400 analysts across our global offices in Asia, Europe, Australia and North America, covering about 97 percent of the public company universe, which gives us huge insights for due diligence and supply chains and other important factors.

When it comes to ESG in private credit, how can managers make an impact and how does that differ to the public markets?

In the public markets, where we have a fair amount of experience, ESG strategies have existed for years and are generally more advanced than private markets. At Fidelity, we have a philosophy of engagement over exclusion, so rather than exclude companies from access to capital we like to use our capital to drive change.

We encourage change through the commitment of our capital as part of our lending proposition. We engage with borrowers and look to measure the changes they are implementing over time, throughout the life of our loan, and reward them for achieving targets.

We help our companies build their ESG strategies. If certain milestones are met, we will reduce the margin on the loan. If milestones are not hit, we will seek to implement upward ratchets to really encourage companies to focus on those areas.

This is not just about the benefit to society. The risks and opportunities we assess around ESG are also important when assessing the broader creditworthiness of our companies. Sustainable companies will be stronger companies and will be more attractive when private equity looks to sell or refinance. The risk of repayment is, in our view, reduced if a company follows a proper ESG plan.