This article is sponsored by LCM Partners
Are the fears of an economic downturn being reflected in private debt markets?
If you look at the way people are spending money at the moment, you would be forgiven for thinking everything is fine and there isn’t about to be a recession.
Central banks are being disrespected. Interest rates are rising and yet the market is not responding in the way that it should. People are no longer listening to what the central banks are saying. They are not reducing consumption. This may be a by-product of the vast amounts of money injected into the system during covid, but it’s a worrying sign.
The reality is that we are on the cusp of a recession. If you look at the fourth quarter of last year, revenues at many of the large investment banks were down by 50 percent. Corporate financiers are still sitting on their hands. These are the main players that raise money for companies to invest, grow and make acquisitions. This further demonstrates that companies are not growing. Real incomes are falling. This is happening right in front of our eyes, and yet many people can’t see the clear picture ahead of us.
My guess is that central bankers will continue to raise rates until consumption starts to come down and until the markets start to listen to them. Eventually consumers and the SME community will have to stop spending, and start to address some of the challenges facing the market right now, such as rising mortgages and higher living costs. This has not yet happened.
Many of our competitors have major refinancings coming up in 2024 or 2025, and they are starting to ask themselves, “How are we going to do this?”. It’s very difficult to raise capital for private equity deals at the moment. Mid-market sponsored loans are completely out of favour and many people are trying to figure out how they price private equity deals in the current environment.
This is a real challenge, but the pressure that many of those businesses are facing at the moment plays to our strengths.
How is the looming threat of a recession impacting the business that you do?
There are two distinct elements to this. Banks are setting aside reserves in the anticipation of an economic downturn, but there hasn’t really been any single event that has forced people to stop paying their bills or alter their spending habits. We’re seeing vacant shops on high streets, but we’re not seeing any large-scale defaults or any big bankruptcies. The build-up to this economic downturn has been fairly gradual and this is why I often refer to it as “death by a thousand cuts”. In time, this is going to result in more supply of non-performing loans coming to market and a greater opportunity to lend where the banks can’t.
At the same time we’ve been watching our competitors’ behaviour. While we do not have any leverage on our balance sheet or in our portfolios, which to an extent shields us from interest rate rises, the same is not true for many of our peers. We’ve been approached by a number of other market participants to help them out with liquidity and we are more than happy to do so if that results in some good deployment for our investors. This is central to the work that we do and benefits our market as a whole.
We celebrated our 25th anniversary this year and this is the first time we have seen market conditions like this.
Why are your competitors coming to you?
There are two clear reasons for this. First of all, we are the largest pool of capital in the consumer and SME space in private credit. Secondly, our lack of leverage gives us more flexibility over pricing.
“Eventually consumers and the SME community will have to stop spending, and start to address some of the challenges”
For example, assume that the cost of funds is 12 percent today. This means in order to make any money, returns on investment must be at least marginally above this. However, before interest rates started to rise the typical cost of funds would have been much lower, perhaps between 2 percent and 5 percent. At that time many funds relied on leverage in their strategies to achieve 12 percent returns on investment, resulting in an attractive spread of 7 percent or more.
What does this mean in the current environment? Are funds realistically going to be able to achieve 19 percent returns to maintain that spread – or do they need to find a way to buy cheaper assets? These are some of the questions that levered buyers are now having to ask themselves.
If you don’t have that stress on your books in terms of leverage, as we don’t, then you are in a fortunate position where you can bid 12 percent for an asset and still make money for your clients. This is not by accident. We have deliberately designed things to work this way.
Have you noticed much of an increase in organisations offloading their European non-performing loans as a result of the declining economy?
The numbers haven’t spiked up yet. People are still in denial. As I said, I see this is as “death by a thousand cuts”. Although banks have been increasing their reserves in anticipation of a recession, there hasn’t been a noticeable increase in the impaired loan figures yet, even if we have seen an uptick in our own deployment over the past two quarters.
What we’re seeing instead is a rise in the sale of performing loans. Banks are pivoting towards scale. They are trying to get rid of some of their smaller portfolios or looking to exit particular lines of business altogether. And they are selling these to us to achieve a clean break. In some cases we’ll take over their teams and they’ll become a part of our future.
Our raison d’etre is to make lending institutions more efficient. We’ve been able to support them in this regard, but the worsening economic situation and the pressure that other organisations on the buy-side are now facing makes this more important than ever. This is how our footprint is continuing to grow.
Banks are coming to us because we’re seen as the strongest counterparty in Europe in what we do. They remember the billions of dollars of fines that were handed out during the global financial crisis, so are hypersensitive about the buyers of their portfolios and their reputation.
There are a few countries where exceptions will be made, but in the more sophisticated countries, banks endure rigorous oversight from their regulators and national central banks about how they behave and where their loans end up. And that’s a good thing. As an integral part of the financial community, we’re an approved counterparty for a lot of these banks and are excited about the opportunity that lies ahead of us.