For the first time in decades, fears of high levels of inflation are weighing on the minds of asset managers. Private credit funds had been largely untroubled by inflationary concerns as they built their portfolios in the wake of the global financial crisis, but all indicators suggest that is about to change.
Statistics from around the world in early 2022 make for grim reading. The Bureau of Labor Statistics in the US announced in February that the American consumer price index rose by 7.5 percent year-on-year in January, a level not seen since the 1980s. The UK is not far behind, with prices rising by 5.4 percent at the end of 2021. In the eurozone, inflation hit 5.1 per cent in January, its highest level since records began in 1997. And those figures predate the outbreak of war in Ukraine, with its inevitable impact on already escalating fuel prices. In early March, oil prices jumped to their highest levels since the financial crisis as the US and Europe announced plans to ban Russian oil imports, cutting off the world’s third largest oil producer.
“We believe the market will favour those who stay disciplined and remain true to their underwriting principles”
Twin Brook Capital Partners
As consumers prepare for a hit to petrol prices and heating bills, mid-market businesses are feeling the pinch of inflation across labour costs, supplies and raw materials, and freight and distribution costs.
Drew Guyette, senior partner and chief credit officer at US mid-market credit firm Twin Brook Capital Partners, says: “As we sit here in early March, it is freight and transportation costs where we are seeing the biggest inflationary pressure. 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.”
Job vacancies are also reaching record highs on both sides of the Atlantic, with a tightening labour market pushing up wages and adding further pressure to mid-market balance sheets. Average weekly earnings in the UK grew at an annual rate of 3.7 percent in Q4 2021, with job vacancies at their highest levels since records began in 2001.
Chris Bone, head of private debt in Europe at Partners Group, says: “In the UK, as a result of Brexit and the movement of people out of the country, getting sufficient staffing in sectors such as healthcare and hospitality is really tough and people are having to pay more. We definitely see that as an issue.”
His counterpart, Tom Stein, head of private debt in the Americas, says: “The lower-skilled end of the labour market is the most competitive and the most impacted by wage inflation. The big retailers and fast-food chains are going to be most sensitive to it, with highly skilled labour less impacted.”
In both cases, the result is a squeeze on the balance sheets of mid-market portfolios. Stein says: “The thing we are most concerned about is if you have an inflationary impact and you can’t pass that along to your end user or the lag effect doesn’t allow you to get ahead of it. We have been preparing for this in our underwriting processes for some time and looking closely at things like rent clauses and input costs. Our portfolio looks pretty resilient but across the mid-market there are certainly some companies that are much more exposed than others.”
The impact of inflation on businesses is both sector and company specific. Bone says: “Where a company sits in the value chain and the sector it is in are the biggest determinants of the impact of inflation. If you look at the strength or importance of a company in the value chain, measured by EBITDA margins, that’s often the best proxy. We average an EBITDA margin of about 30 percent across our portfolio, which means we have quite a lot of pricing power in our companies. It doesn’t mean the portfolio is insulated, but it gives us some comfort.”
Throughout the instability of the past two years, direct lenders have gravitated to less cyclical industry sectors in a bid to shelter their portfolios from the highs and lows of economies. Such an approach continues to make sense as a cushion against inflation.
Robin Doumar, founder and managing partner of Park Square Capital, says: “We have had this broad concern about inflation for some time, and until early February our focus was on supply chain disruption, commodity price increases and constrained capital expenditure during covid butting up against strong consumer demand. Since the escalation of tensions in Ukraine we have seen energy prices spike and the biggest immediate threat is to industrial companies, airlines and other businesses where fuel is a big component of the cost base.
“More than 70 percent of our portfolio is in healthcare, software and business services, where the impact of raw material price inflation is going to be limited. We have analysed our portfolio against some pretty robust inflation assumptions and it looks just fine, but for the market as a whole, things look challenging. We’ve seen a lot of deals with very high leverage, interest rates have been super low and are going to go back up, and all of that is problematic.”
Guyette says the ability to push through price increases to consumers will be a key determinant of the level of stress in portfolios: “Whenever you’re beholden to concentration or long-term contracts, there is a downside to that. If you have diversified customer and supplier relationships that allow you to purchase frequently, and that diversification allows you to maintain pricing power, you should be able to push through price changes on a regular basis.
“Where I think we are going to see the most pain is in the upper to core mid-market, because a lot of those businesses rely on long-term take-or-pay contracts alongside customer or supplier concentration.
“We have seen a tremendous amount of resilience in the lower mid-market, as those companies’ business models typically operate in a just-in-time fashion and they are often market leaders in niche segments of their industry, where there are high barriers to entry or they are delivering a critical service. If you are manufacturing a critical part that’s a small cost in relation to the overall end product, inflationary pressures around those small inputs are tolerable to the end user. There’s a lot of resilience in the lower mid-market when it comes to margin preservation.”
While sectors like software and business services may be more resilient, credit managers across the board will be dealing with more cost pressure than they have seen in a long time. Some of those cost spikes will be transitory, as companies work through supply chain blockages from covid or as the immediate impact of the war in Ukraine hits energy prices. But others may be here to stay, driven by mega-trends like energy transition and onshoring to address supply chain vulnerabilities.
“For the market as a whole, things look challenging”
Park Square Capital
Doumar says: “We are going to have an extreme bump in the short term and that will taper off a bit, but a lot of these inflationary pressures are going to stick around for a while. This all really reinforces the importance of fundamental credit picking skills and knowing what you want extremely well. We have gone from an environment where a rising tide has floated all boats into choppier waters, and the people that are going to be successful will be those with real conviction around the investments they have made.”
Guyette adds: “We have a fundamental belief that, as senior lenders, we are meant to underwrite the flat case of a borrower. Growth is important, but your debt structure has to work in a flat environment over five or six years. Volatility usually favours the disciplined lender, and we are not beholden to growth for us to be comfortable in our capital structures.”
It is a view shared by Bill Sacher, partner and head of private credit at Adams Street: “Given the effects on underlying borrowers of rising inflation and rising interest rates, credit selection is going to be more important for credit managers during this period. Managers that get that right will likely have the benefit of better performance over the next few years.”
He maintains that the combination of inflationary pressures and rising interest rates will create challenges but the market dynamics will continue to favour the mid-market direct lender. “As a general point, when compared to other types of debt, private credit is particularly well-positioned for an inflationary environment that includes rising interest rates, given its floating rate nature.
“As soon as there are increases in short-term rates, private credit loans will typically get the immediate benefit from that. The expectation in a rising interest rate environment is that the yields or returns on private credit will go up; thus the exposure to interest rate risk that is common within fixed income credit is significantly reduced in private credit.
“It is therefore our expectation that those dynamics will further enhance interest in the private credit asset class as well as the total amount allocated to, and resultant capital flows into, the asset class. On balance, we remain bullish in our outlook for the coming year even given the challenges in the macroeconomic environment.”
Guyette argues that direct lenders will also see a chance to strengthen relationships: “The opportunity for direct lenders is to step up and be responsive as a supportive partner. If you have experience as a lender through different working capital cycles, many borrowers will look to benefit from that knowledge and expertise. We believe the market will favour those who stay disciplined and remain true to their underwriting principles.”
Mid-market direct lending portfolios could be in for a bumpy ride, but the asset class looks well-positioned to endure and even benefit from economic instability.