Goldman Sachs on why it’s time for a flexible approach

Market dislocation promises to produce a rich seam of opportunities for investors adopting more flexible capital solutions for portfolio companies, say Goldman Sachs partners Stephanie Rader, Beat Cabiallavetta and Moritz Jobke

This article is sponsored by Goldman Sachs Asset Management

How is the new macroeconomic environment impacting LP attitudes towards private credit allocations?

Stephanie Rader: Given ongoing volatility in public markets, LPs are looking to increase or maintain their allocations to private credit.

While in the past they may have primarily focused on cash-yielding performing loans through senior direct lending and mezzanine strategies, they are now also looking to capitalise on market dislocation to achieve higher returns. LPs are willing to forgo some recurring income in return for greater long-term capital appreciation, leading to increased demand for hybrid capital.

How should investors be thinking about balancing exposure between income-orientated credit and higher yielding, capital appreciation strategies?

SR: Many LPs are overweight towards income-oriented strategies with limited upside. As LPs look to optimise their risk-adjusted returns, they are increasingly looking at hybrid strategies that focus on capital appreciation. A strategy that spans both debt and structured equity can serve as a bridge between private credit and private equity, achieving higher returns without sacrificing the downside protection that LPs seek in private credit.

How do distressed and hybrid strategies differ?

SR: Typically, a distressed strategy will involve exposure to public markets and a focus on loan-to-own. Upside is achieved through the potential for equity ownership if covenants are breached, or if there is an out-of-court restructuring or an in-court bankruptcy. Distressed strategies offer higher returns in exchange for higher risk but are also very market-dependent.

“A strategy that spans both debt and structured equity can serve as a bridge between private credit and private equity, achieving higher returns without sacrificing downside protection”

Stephanie Rader

Hybrid strategies focus primarily on direct origination with deployment opportunities through the cycle, allowing the GP to structure flexible solutions that meet the needs of borrowers while also providing strong risk-adjusted returns.

How does the current period of dislocation differ from the pandemic?

Beat Cabiallavetta: The pandemic was a massive shock, with revenues for many companies declining overnight as economies partially shut down. Although that crisis was unchartered territory in the initial stages, there was an immediate need for cash. This dislocation created an attractive investing environment. However, a clearing level for risk was found relatively quickly as central banks flooded the market with liquidity. As a result, the dislocation was much shorter than initially anticipated.

In today’s environment, we are going to experience a much longer and deeper cycle. Revenues are under pressure, margins are compressed from inflation, and geopolitical tensions are causing uncertainty. That said, the adjustment to higher rates and a weaker economy has felt fairly controlled so far. Higher quality companies have liquidity, generally resilient balance sheets, and runway with staggered debt maturities. The rise in the cost of capital and adjustment lower in valuations has significantly slowed down deal activity. This will play out over a much longer period.

What type of opportunities are you seeing as a result?

BC: We aren’t observing the urgent need for cash that we generally see during dislocations. Instead, there are more take-private transactions of companies trading at attractive valuations in an environment where financing is not readily available. There is growing demand for structured equity investments from higher quality growth companies. However, we are still in the early stages of an opportunity for hybrid capital to partner with companies and their shareholders to find ways to de-lever, fund inorganic growth, and work on monetisation options.

Can you elaborate on the use cases of structured equity and how LPs think of structured equity in their private credit allocation?

BC: Structured equity sits in the middle of the capital structure with characteristics that mimic those of credit instruments such as downside protection and a minimum return yet allow for embedded upside participation. With higher interest rates, companies need more cash to service debt. This leaves less cash for growth and makes it more difficult for shareholders to generate value. Structured equity solutions, which can improve leverage ratios and offer cash for growth, are an attractive option for companies in this cycle.

“Structured equity solutions, which can improve leverage ratios and offer cash for growth, are an attractive option for companies in this cycle”

Beat Cabiallavetta

SR: One other point I would highlight is that, as companies stay private for longer, there has been more of a focus on optimising balance sheets and developing flexible capital solutions that mutually benefit both the GP and the portfolio company.

In terms of how investors view structured equity, I think more LPs are becoming comfortable with structured equity within their private credit allocation. While these equity solutions are underwritten with a focus on downside protection, they also have upside potential creating a diversification of returns. We believe hybrid capital strategies involving structured equity will continue to gain interest as LPs look to expand their private credit portfolios.

Shifting focus to Europe, what is the opportunity set in the region today?

Moritz Jobke: In Europe, there are three dominant themes in the types of transactions we are seeing. First, in acquisition finance, take-privates are driving activity followed by bolt-on acquisitions.

The second theme involves refinancings. In the current rate environment, some companies can no longer balance the investments required for value-generative growth with the cashflows available after debt service. Those businesses, though fundamentally sound, require complex solutions to deliver on their equity thesis.

The third theme is around structured equity. This is becoming more important as deal frequency in private equity has slowed and GPs need to generate liquidity on existing portfolios. Managers want to hold on to these companies without crystalising value at an inopportune time.

How does Europe differ from the US in terms of market dynamics, structures and opportunities?

MJ: There are a number of differences, including the size of the market, as well as legal and ratings frameworks. The depth of the US market and its legal framework drive more complex capital structures. As an investor in Europe, you have to contend with a diverse set of legal frameworks, differences in market dynamics and participants between the major countries. The reach and network of the Goldman Sachs franchise, along with our long track record, are significant advantages.

While the US has progressed further in terms of risk appetite, Europe is a very attractive market for us right now, as constrained first-lien capacity is pushing demand for capital into the subordinated space where there are few providers who can deliver in real scale.