Private debt markets have defied the doubters over the past 12 months and roared ahead in terms of both dealflow and fundraising. The mid-market has proved no exception. All the fund managers we talked to for this report say that it was an exceptionally strong end to 2021 and they went into this year with a justifiable sense of optimism, writes Graeme Kerr.
“We are coming off arguably the busiest couple of quarters in the history of our firm and arguably for the middle market private credit industry as a whole,” says Jason Strife, head of private equity and junior capital at Churchill Asset Management. “From our platform’s standpoint, our deployment of senior and junior loan capital was nearly $9 billion last year, which was a 100 percent increase versus the prior year. Our Q4 figures alone were half of that annual total. We saw an incredible acceleration in the second half of last year.”
But there are clear signs that the macro concerns – the spike in inflation, supply chain disruption and the fallout from Russia’s invasion of Ukraine – are starting to bite.
So, what do the next 12 months bode for mid-market lenders? Which sectors are likely to emerge least battered by the headwinds and how will investors react to the uncertainty ahead? Here are five key trends that we expect to dominate the mid-market over the next 12 months.
Inflation will cast down on the market
Inflation has been so low for so long that fund managers could be forgiven for uncertainty about how to deal with current concerns. One thing seems clear: inflation is starting to bite, at levels higher than feared last year.
“As we sit here in early March, it is freight and transportation costs where we are seeing the biggest inflationary pressure,” says Drew Guyette, senior partner and chief credit officer at US mid-market credit firm Twin Brook Capital Partners. “The costs of shipping products are largely influenced by oil, and we have already seen a relatively significant movement in the price of oil this quarter compared to the fourth quarter. At the same time, some companies are making the choice to go from water shipment to air freight, and whenever you seek to move to more of a just-in-time delivery, that costs more.
“This is definitely business- and sector-specific right now. Asset-light businesses with low human capital requirements are less concerned about inflation. If you’re creating products that need to be shipped across the US, it’s a real issue.”
The situation in Ukraine is bolstering these fears, especially in Europe. “In Europe we perhaps feel closer to what is going on in Ukraine,” says Chris Bone, head of private debt Europe at Partners Group. “Everyone is diving into their portfolios and working out their exposure to Russia, which is small for us and probably for most of our direct peers.
“But secondary and tertiary effects are pronounced, especially on energy prices if Russia fully turns off the gas supply to Europe at a time when prices are already high. Agriculture and related sectors are also impacted.”
Maintaining discipline is essential
Experience is likely to be critical to cope with the challenges ahead, with conditions set to favour the more established fund managers. “The depth of our pipeline allows us to be highly selective when constructing our diversified loan portfolio,” says Mick Solimene, managing director and portfolio manager at Monroe Capital. “In the lower mid-market, too, there isn’t the same kind of pressure to give up documentation protections or loosen or forgo covenants.
“Another factor is maintaining strict investment discipline around acceptable leverage, loan value and liquidity levels. Inflation, if it starts to impact margins, can affect these metrics over the life of a loan.”
Established relationships remain incredibly important, especially in the lower mid-market, says Grant Haggard, senior partner at Twin Brook Capital Partners. “For many sponsors, working through the pandemic-related disruption has reinforced the value of having long-term, reliable lending partners that have a deep knowledge of their businesses and will work hand-in-hand with them through challenging times as well as periods of growth. As a result, we’ve seen the scaled, experienced lenders continue to gain market share.”
Supply-chain disruption is a definite worry
Adding to the inflationary worries are the ongoing issues with supply chains. “The challenges that we are confronting today largely revolve around inflation, tight labour markets, shipping challenges and rising freight costs, all of which have impacted mid-market US companies in a relatively widespread way,” says Bill Sacher, partner and head of private credit at Adams Street Partners.
“We are not yet at a point where the market is expressing broad concern about credit quality and rising default rates,” says Sacher, “but margins are under pressure, and we are starting to see some softness in the underlying performance of certain businesses.”
One beneficiary is the logistics sector. “The logistics space has become a particularly attractive part of the market in the last six months, supporting supply chains in the face of significant disruption around the world,” says Partners Group’s Chris Bone. “There are plenty of opportunities, in everything from logistics software through to freight forwarding businesses.”
But there are concerns the logistics market has become overpriced. Natalie Howard, head of real estate debt at Schroders Capital, says opportunities are rife in European real estate credit, where, she says, alternative lenders are in short supply, but she believes the logistics sector to be unrealistically priced. “Interestingly, what we are unlikely to do too much of is logistics, because those assets are keenly priced based on growth projections that haven’t actually happened yet,” she says.
Sector specialism is growing …
One definite trend is the move towards funds that are more sector specific. Monroe Capital has made the switch towards sector specialism: first with a healthcare-focused lending business, subsequently followed by business services, recurring-revenue software and technology, media, consumer and real estate.
Ted Koenig, Monroe chairman and CEO, tells us: “In private credit we were generalists, and I was finding the market competitive and investors hungry for yield. It is hard to show differentiated yield when there are a hundred private credit managers all chasing the same leveraged loans.
“In order to address the needs of our LPs, we continue to further differentiate our returns by going after sectors.”
In the tech sector, Tree Line Capital Partners is targeting software lending based on annual recurring revenues. “We’ve seen a significant increase in interest among private equity in software and technology deals,” says Frank Cupido, partner at Tree Line. “Our research of sector performance has continued to show that software transactions exhibit the lowest likelihood of default.
“Driving this are fundamental credit dynamics typically sought by lenders including high revenue visibility driven by contracts with robust customer retention, high switching costs resulting from the mission-critical nature of services provided by software, and strong sponsor support with low loan to value ratios.”
Data researcher Kroll estimates that software M&A achieved almost $500 billion last year, $247.7 billion more than the previous high of 2018. In Europe, technology accounted for 24 percent of all mid-market debt deals completed in the first half of 2021, the highest of any individual sector and up 2 percent over the second half of 2020, according to Kroll.
Another favoured sector is healthcare, where there are numerous opportunities as outlined in our A-Z of Healthcare.
Paul Johnson, partner and head of direct lending at Bridgepoint Credit – whose parent company Bridgepoint is owner of Private Debt Investor publisher PEI Media – says that, over a period of volatility, resilient sectors of the economy such as technology and healthcare are proving their worth. “We have been investing in sectors like healthcare and technology-enabled services since our first direct lending fund, positioning us well to source and make investments in these spaces and accurately assess diligence risks, helping us avoid losses,” he says.
… but there’s still a role to play for the generalists
While there are merits in a sector-specific approach, there are advantages too in being sector-agnostic. Christine Farquhar, global co-head of the credit investment group at Cambridge Associates, who oversees manager and market research across public, hedge fund and select private credit strategies, says generalists will always be an important feature of their portfolios.
“The way we see this is that in senior secured the generalists are still dominating; this is credit and we don’t want extra risk,” says Farquhar. “We just want to capture the illiquidity premium, so the benefit of the generalist is that in credit you want to create as much diversification as possible.
“The generalist is also more likely to have the workout and legal expertise on hand if something goes wrong.”