Friday letter: The same but different

We're still thinking about those headline-grabbing energy sector losses this week, not least because struggling credit strategies are being attributed to the drop in oil prices. But it's not as simple as that.

Earnings season is in full swing and not just the trade press have been full of debate about which PE firms were hardest hit by the sharp plunge in oil prices in the last quarter of 2014; Carlyle, Apollo and KKR – some of the biggest names all reported sizeable write-downs.

But these are, in the main, paper losses. If or, quite likely when, oil prices recover, many of those investments will similarly benefit. It was the performance of credit that PDI kept a sharp eye on, and the message from David Golub, of Golub Capital, was an interesting one.

“We’re finding middle-market junior debt to be downright unattractive right now. Attachment points are too high, pricing is too low and structural protections, including covenants, are weak. This is an area where we have not seen a meaningful degree of widening—spread widening or structure improvement—since September. We think this is a situation where there are too many players chasing too few middle market junior debt deals and consequently we’re sticking with our strategy of de-emphasizing junior debt at this time,” Golub said.

This was a salutary reminder that segments of the credit market are getting congested as firms look to redirect and refocus their strategies.

Notable too was Apollo Global Management’s results, which failed to meet analysts’ estimates. The firm’s actual economic net income (ENI) per share of 23 cents, missed the consensus estimate of 38 cents and recorded a whopping 80 percent drop from 2013’s figure of $1.12 per share.

Much of Apollo’s poor performance can be laid at the door of the energy sector. It has a 40 percent stake in EP Energy, which has taken a massive hit in terms of stock price.

But it is the roughly $67 million year-on-year fall in ENI from the firm’s credit business that should sound a warning to debt investors. The firm’s official earning statement clarified the reasons for the fall a little: “The year-over-year decrease in ENI of $66.8 million was primarily driven by a net reversal of carried interest income of $33.5 million during the fourth quarter ended December 31, 2014, compared to carried interest income of $74.2 million for the same period in 2013.”

So as credit returns slowed, the firm failed to reach the target at which carried interest kicked in across a large portion of its credit business. A portion of that, again, can be attributed to the volatility in the energy sector – before private funds can make money from the dislocation in energy markets, they must take the hits – and Apollo blamed energy for much of its credit pain. Yet without a full breakdown it’s hard to quantify the exact toll, but it seems unlikely it can be entirely blamed on slumping oil prices.

Private Debt Investor does not believe that medium- to long-term investment decisions should be based on a single bad quarter of course. In fact, reporting requirements sometimes seem geared solely towards the more volatile equity markets. Private debt investing is different to that.

Yet this earnings season should not be wholly discounted, as it evidences that credit targets in some areas are proving much harder to meet. The market should take note and remember that flexibility is key to sustaining success. Just be careful you and 100 of your competitors aren't trying to do the same thing.