This article is sponsored by KKR
What are the prospects for private debt in today’s environment of macroeconomic volatility?
Private credit is benefiting from a number of tailwinds. The secular shift among issuers from public to private credit markets tends to accelerate during times of market volatility, and with syndicated debt markets closed for business, many borrowers are left with little choice but to seek private credit solutions.
Private credit has quickly become a mainstream asset class and a viable option for borrowers looking to finance their transactions. Indeed, many borrowers are accessing the private credit markets for the first time, including issuers that would normally finance themselves with traditional, broadly syndicated loans. In the last 18 months, we have seen the emergence of jumbo deals (unitranches of more than $1 billion). We expect this trend to continue long after the market normalises.
Likewise, private equity firms have built up a record amount of dry powder that must be deployed in the medium-to-long term, and their deals will require financing. Even with capital markets stalled and M&A at a standstill, some private equity activity is happening for strategic M&A and refinancing. With bank retrenchment likely to continue, we see an increasing demand for private credit.
Finally, the floating interest rates of private credit financings are attractive in inflationary times. As investors show greater interest, we think private credit managers will be able to raise larger funds and compete for larger deals, thereby taking further market share from the broadly syndicated markets. Considering the current economics and broader terms available for financings, we think this could be one of the most attractive entry points for investors into private credit.
Is it possible to take a view of prospects for the asset class, or are there very different outlooks for different parts of the market?
Overall, we think there will be continued growth in private credit, but growth will come from different asset classes at different times depending on prevailing market conditions, and in particular corporate private credit and asset-based finance (ABF).
On the direct lending side, we see the growth of mid-market private equity funds as a positive force. The increase in leveraged buyouts of companies with EBITDA of between $75 million and $200 million should increase the demand for upper-mid-market financing. The threat of new entrants to this area of the direct lending market is limited given the scale needed to compete, so managers already active in the space should benefit. We think the larger end of the mid-market looks particularly attractive, as big businesses historically have tended to be more resilient to economic cycles. In an inflationary environment, choosing larger businesses that are leaders in their field and have defendable margins is very important.
We believe that junior debt in these kinds of larger, industry-leading businesses deserves investors’ attention, especially once the syndicated market starts to reopen. Private junior debt in our view offers attractive risk-adjusted returns relative to those of equity and senior debt, combined with the high levels of equity subordination often found in defensive companies that generate healthy levels of free cashflow.
We’ve observed from our ABF strategy that the high-inflation environment has drawn many investors towards floating-rate, collateral-based assets. A multi-asset class approach to ABF allows us to be responsive to the macro environment and shift our focus to opportunities such as secured lending, which includes mortgages, equipment leasing and auto finance, with an emphasis on more prime borrowers.
Which areas of the market look most exciting over the next 12-18 months?
We believe there are particularly exciting opportunities in three distinct areas: direct lending strategies, including junior capital investments that offer double-digit returns with high levels of equity subordination; flexible mandates that can quickly pivot across public credit, private credit, real estate credit and equity; and non-corporate contractual cashflows with low correlation to the broader market.
What views are you hearing from investors? Are they still keen to commit, and have their priorities changed?
The secular trend of increasing allocations to alternatives continues. Chief investment officers seem more determined to pursue private credit given the recent market volatility and broadly floating-rate nature of private credit.
On the other hand, investors have been very busy allocating to private credit in 2022. As a result of the denominator effect – in which the share of private debt in portfolios has risen simply because public debt and equity valuations have taken a steeper fall – many investors feel appropriately allocated for 2022 and have decided to take a pause for now, while positioning themselves for new allocations in ~2023.
We are working closely with them on tailored solutions that can help them increase allocations in the areas where they see the most value or diversify existing private credit holdings. Diversification is a key theme, particularly for our ABF, junior debt and Asia Credit businesses, where investors do feel underinvested relative to their broader allocations.
Do you see the nature of the investor base transforming? You’ve been at the forefront of attracting a wider range of individual investors, for example.
Yes, we see a surge in demand for so-called democratised products, which would give private wealth investors access to alternatives. This is a step change for private credit. We believe that a chasm will open up between managers who can access private wealth capital and those who cannot.
This goes back to the idea that size matters for managers, both because it increases their relevance to issuers and owners and because it gives them the ability to lead larger deals. Managers that predominantly relied on pension fund capital will soon find out that they need dedicated and differentiated products, such as private wealth or insurance products, in order to keep up with the changing nature of the investor pool.
How does the view of private debt look from Asia-Pacific, compared with the US or Europe?
Asia-Pacific private debt markets remain underdeveloped compared to those of the US and Europe, and therefore represent a growth opportunity for flexible credit providers. In 2021, we estimated that banks represented 80 percent of the credit market in Asia excluding Japan, compared to roughly one-third in the US market and just over half in the European market. Local privately owned companies and small-to-medium enterprises may have limited access to this channel given formulaic bank lending standards and the difficulty of pricing idiosyncratic situations, as well as the transitions underway in some companies and industries. Each of these factors creates the need for private credit.
Yet private credit capital is scarce in the region. We estimate that the ratio of private equity to private debt assets under management in 2021 was 31.5x in Asia compared to 5.3x and 3.8x in the US and Europe, respectively. The current dynamic in the Asia-Pacific region is similar to that of Europe over a decade ago, when banks provided the vast majority of capital for private equity buyouts. Private equity sponsors in Europe have increasingly turned to private credit for financing solutions. We are beginning to see a similar story emerge in the Asia-Pacific market, albeit with variation at the local level.
What’s the key to success in the coming years – in general, but also from a specifically Asia-Pacific perspective?
In corporate private credit, relationships with top-tier private equity sponsors will continue to be key. It is important to be the first call private equity firms make to gain access to proprietary deals. A differentiated origination platform to systematically source sponsorless/corporate transactions is also critical.
At KKR, we are constantly thinking about “more ways to win”. We feel this is particularly relevant to our ABF business, where a multi-prong approach allows us to lean into opportunities wherever they arise, whether by investing in hard assets through portfolio acquisitions, capturing asset flow through financing platforms, or trading across the capital structures of private asset-backed securities.
In Asia specifically, a pan-Asian investment process needs to take into account local cultural, language and legal considerations. Business is conducted differently in each country, and successful managers need the scale and expertise to operate in different markets and choose the best deals from across the region. KKR has some 250 employees across six core areas in the Asia-Pacific region, which we feel is a differentiated competitive advantage.
Is the competitive environment likely to ease, or become even more intense?
Competition can arise from too much capital chasing the same deals, too many lenders offering a commoditised product, or deals that require little specialisation. We believe that competition will continue to be fierce at the smaller end of the mid-market, where barriers to entry have been low.
We think consolidation is likely in this segment of the market, as scale is a competitive advantage, particularly in corporate private credit. We see a future in which a smaller number of larger players drive transactions and influence pricing and terms, rather than a fragmented array of smaller players who must by their nature act as price-takers. In ABF, on the other hand, specialisation is critical, and we think the numbers of players in this space will continue to be limited.
Does ESG continue to be a prime focus? How far have fund managers/investors progressed with ESG, and what innovations are we seeing?
Yes, although we believe that a greater divergence will emerge between those who “tick the box” on sustainability and managers that have invested time and effort into weaving ESG considerations into their credit investment processes. Serious managers cannot rely solely on market providers of ESG data, as they do not have sufficient coverage of sub-investment-grade credit markets. In light of this, KKR’s credit team has developed its own proprietary ESG scorecard. Recognising the valuable perspectives of outside experts, we engaged third parties to analyse our process and scorecard and provide feedback. We see this kind of pressure-testing as critical given the fast evolution of the ESG space.
Credit investments across our platform are now scored to help analysts identify and discuss key ESG issues and risks at the due diligence stage of our investment process. This process feeds into what we call our “ESG Credit 2.0” framework. We believe this new framework creates a strong foundation for (a) unearthing meaningful ESG-related trends and incorporating ESG-focused operating procedures into our investment processes; and (b) identifying opportunities to invest into sustainable solutions and ESG-committed companies, both now and in the future.
What will surprise us about the private debt market in a few years’ time?
The syndicated market and private credit will coexist, and the line between them will blur. We will see borrowers move across markets depending on the market cycle and type of deal. Plain vanilla deals will be financed in the cheaper syndicated market, while more complex deals that require customised terms or flexibility will look to private credit.
We also believe that the traditional divergence between the performance of equities and bonds will continue to disappear. As investors in these asset classes continue to react in similar ways to market movements, the two asset classes will become more correlated. That, in turn, threatens the traditional role of fixed income both as a cushion for poor equity performance in volatile markets and economic downturns and a portfolio diversifier. We believe investors will face more pressure to re-evaluate the traditional 60/40 equity/bond portfolio construction approach, and part of the answer is likely to be diversifying the bond portion with private credit.