Loan Note: Defaults on the up but maturity fears misplaced; two different views of private debt prospects

Defaults in private credit are on the rise, but unlikely to go much above historic averages; SR Alternative Credit outlines five reasons why the asset class is poised to flourish; while a State Street survey challenges notions around investor preferences. Here's today's brief for our valued subscribers only.

They said it

“Deployment in private markets has slowed down and we have reached a crossroads: it takes (more) time to agree on value in this new context”

Taken from an AllianzGI study, Outlook 2023: Private markets at a crossroads.

First look

Defaults on the rise: but only to normal historic levels (Source: Getty)

Back to the future for defaults
It’s a given that private debt defaults will rise due to economic slowdown, but the question is by how much? A market comment from Christophe Fritsch, global head of alternative credit at AXA IM, suggests a return to long-term averages.

As some companies struggle with increased costs and the effects of monetary policy, Fritsch says a default rate of around 3 percent may be expected. This is the same as the US leveraged loan long-term default rate and slightly higher than the equivalent rate of 2.5 percent for European leveraged loans.

It is a case, as AXA IM suggests, of going “back to the old normal” after many years of historically low defaults against a backdrop of exceptionally low interest rates. “Companies with strong cashflows and the ability to pass on inflation should continue to fare well,” says Fritsch.

He adds that fears about the loan maturity wall are premature, with data from JPMorgan showing loan maturities peaking between 2025 and 2028.

Fritsch’s overall view is upbeat: “It may appear strange to find a head of asset class so optimistic after a tough 2022. But we are returning to an environment in which higher dispersion in markets provides an opportunity to deliver strong performance in selected asset classes.

Five reasons to keep the faith
Want a safe harbour in stormy seas? Private credit fits the description according to Sam Adams, a portfolio manager at SR Alternative Credit, in a comment on the asset class’s prospects in 2023. He identifies five reasons why private credit should be a top investor choice:

1. Hedge against inflation: With many investments being floating rate, private debt can provide a natural hedge against inflation and provide some of the highest yields in the fixed income world. These loans also tend to be structured with interest rate floors, protecting returns when inflation falls.

2. Reduced market correlation: Private credit is not subject to mark-to-market volatility and has a long tenor, which also cushions market effects. Moreover, asset-backed loans are normally collateralised with assets that are less subject to price volatility. Collateral top-up and reserve requirements provide further insulation against macro developments and market fluctuations.

3. Principal protection: Secured lenders can protect their principal investment against deterioration or loss, even in the case of borrower default. This contrasts with equity investments which, as demonstrated on the stock market over the past year, are fully exposed.

4. Tighter control over assets: Individually negotiated and tailored transactions allow lenders to adjust terms to take into account each borrower’s unique circumstances and the special features of each industry. This yields a close understanding of each borrower, promoting well-structured financial and other covenants, and stronger reporting.

5. Underserved market: Private credit offers investors attractive returns – typical coupons range from 7 to 15 percent – because borrowers are underserved. While private lending has grown substantially in the past 10 years, economic uncertainty and market turbulence will only stoke the need for more privately sourced credit, and this demand may increase returns.

Survey challenges notion of debt’s favoured status
Despite SR’s view (above) of private credit as a safe harbour for investors, a new survey from State Street suggests it’s the least favoured alternative asset class when it comes to new allocations from institutional investors.

State Street’s survey of 480 investors found that private equity was most attractive, with 63 percent of respondents anticipating making it their largest allocation over the next two years. Real estate and infrastructure are next in the pecking order, with 48 percent each, while private credit is the favoured choice for 43 percent.

“Our survey finds that three quarters of respondents believe tougher economic conditions will create discounted opportunities, but investors are likely to bide their time, as at least half feel valuations have not yet fully adjusted,” said Paul Fleming, head of the global alternatives segment for State Street.

Nearly half of investors (47 percent) said they had made changes to their due diligence processes as they put a laser-like focus on deal quality while 42 percent said they had set the bar higher in terms of baseline standards, thereby narrowing the universe of investments they would be prepared to consider.


Runway Growth Capital’s triple promotion
Runway Growth Capital has promoted Edward Chen to managing director, as Yifan Lai and Avisha Khubani advance to principal.

Each will continue to report to Greg Greifeld, Runway’s deputy chief investment officer and head of credit. In their new roles, Chen, Lai and Khubani will be at the forefront of Runway’s investment process.

Runway, founded in 2015, provides growth loans to both venture and non-venture backed companies. Led by founder, CEO and CIO David Spreng, Runway provides senior loans of between $10 million and $100 million.

Chen joined Runway in April 2017 as a senior associate and member of the investment team. In a statement, Runway said Chen has been “integral to the formation and execution of Runway’s investment process”.

Khubani joined in October 2018 as a vice-president. She established the monitoring and valuation departments at Runway. The statement credits her with allowing Runway to “maintain long-term partnerships and help portfolio companies navigate challenging situations.”

Lai joined in July 2020 as an associate and member of the investment team. He became a vice-president last year.

Ambienta launches credit team
Milan-headquartered fund manager Ambienta, which focuses on environmental sustainability, has launched a new credit division to sit alongside its existing private equity and public markets businesses.

The new credit team will be led by Ran Landmann as partner and chief investment officer. He joined Ambienta last year having previously spent eight years as a senior managing director at CVC Credit. Nishan Srinivasan will be a partner and head of origination, having previously been a managing director and global co-head of leveraged finance origination at Credit Suisse.

The firm is planning to raise an Article 9 fund under the Sustainable Finance Disclosure Regulation, with fundraising part of the strategy’s “next steps”.

“Our credit practice will… provide a complementary avenue to partner with sustainability champions not looking to sell controlling equity stakes,” said Nino Tronchetti Provera, founder and managing partner of Ambienta.

European risky credit downgrades increase
Downgrades of European risky credits increased by 13 percent to 54 in the fourth quarter of 2022, more than 1.5x higher than the pre-pandemic level, according to a report published by S&P Global Ratings (login required).

“Operational challenges and inflationary headwinds remained the key factors in downgrades to the ‘CCC’ rating category in the fourth quarter of 2022,” said S&P Global Ratings credit analyst Ekaterina Tolstova. “However, refinancing concerns and market liquidity risks rose materially, reflecting tightening financing conditions and investor risk aversion,” Tolstova added.

Three sectors – consumer products, media and entertainment, and capital goods – together accounted for 47 percent of all risky credits by number, while the UK had the highest volume of risky debt, around 46 percent at the end of last year.

LP watch

Institution: Texas Permanent School Fund
Headquarters: Austin, US
AUM: $42.57 billion
Allocation to private debt: 7%

Texas Permanent School Fund (TPSF) has confirmed a $50 million commitment to Berkshire Bridge Loan Investors-MF1 III, according to its meeting material.

Established in 1966, fund manager Berkshire Residential Investments is a Massachusetts-based firm that specialises in providing equity and debt investment solutions in residential properties across the US.

The Berkshire Bridge Loan Investors-MF1 III fund provides debt in North America across the real estate sector. TPSF has a 7 percent allocation to private debt, which comprises $2.98 billion in capital.

Today’s letter was prepared by Andy Thomson with John Bakie, Christopher Faille and Robin Blumenthal