Loan Note: Europe reaches a fork in the road on rates; Carlyle spies a financing opportunity

Fidelity: Central bankers are at a fork in Europe’s road

In a new report, Fidelity International examines the outlook for the private credit markets in Europe as the fourth quarter begins. It finds that the market has proven resilient and there are reasons for optimism: but that much depends on the direction central bankers take.

The default rate in the European loan market was at a historically low level as the year began, at 0.41 percent. Yet as of August, the trailing 12-month par default rate had risen to 1.27 percent. In context of recent central bank rate increases, that remains modest – well below the average since 2007 of 2.92 percent.

If defaults remain low, then given the floating-rate nature of the private credit space, rate increases strengthen absolute returns.

Michael Curtis, head of private credit strategies at Fidelity International, said: “There are two main paths that central banks could take from here – each with challenges for the market. In the first case, a higher-for-longer strategy would start causing problems for borrowers as rising debt costs push interest coverage ratios lower. On the other hand, central banks could pivot to cutting rates – but this would imply a weakening economic backdrop, bringing troubles of its own to borrowers in this space.”

Carlyle sees opportunity in ‘higher for longer’

“Higher for longer” rates is the expectation that comes through loud and clear in an assessment of current market conditions from Jason Thomas, head of global research and investment strategy at Carlyle Group.

The analysis describes the economy thus: “…an economy at (or above) capacity, with a core inflation rate of 4 percent, a US fiscal deficit larger than any that’s preceded it on a cyclically adjusted basis, and a fixed investment boom in the US (also underway in Europe) to combat climate change and achieve self-sufficiency in strategic sectors like semiconductors and green industry.”

Thomas writes: “This is not a constellation of factors that suggests low short-term interest rates are likely to return any time soon.”

To illustrate the pressure on corporate borrowers of higher rates, the analysis refers to public data from business development companies indicating that 12-month interest coverage ratios have dropped from an average 2.25x a year ago to 1.6x at the end of June this year. This was with a base rate of less than 4 percent. At the current rate of 5.4 percent, ICR drops to just 1.2x – meaning that, over the next 12 months, assuming the same rate and earnings environment, interest may consume a whopping 83 percent of operating cash.

The good news for those focused on doing deals is that Thomas believes this to be an “extraordinary” capital deployment opportunity as “easy money has left more companies in need of external finance at a time when it’s likely to prove very expensive”. He expects to see payment-in-kind notes prosper as a solution to debt service burdens as well as “a wave of spin-offs and asset sales” as businesses seek to access liquidity without further deepening their debt burdens.

A call to LPs

Our LP Perspectives 2024 Survey is now live, and we would greatly appreciate your participation as we seek to understand investor sentiment in the private markets today. Here’s the survey link.

Some pointers on this year’s survey:

LP Perspectives is PEI Group’s annual study of institutional investors’ approach to private market asset classes over the coming year. The survey gathers insight on investors’ asset allocations, propensity to invest, performance predictions and views on the wider market.

The results will be published across all our titles.

Respondents will receive the results of the asset class of their choice as a thank you for completing the survey. PEI Group will also donate $5 to UNICEF for each completed response.

The survey takes no longer than 10 minutes to complete, and all submissions will remain anonymous.

The deadline for submissions is Friday 6 October.

Essentials