They said it

“With the rising possibility of hard landings in the US, Europe and emerging markets, this will be the first test since the global financial crisis of whether non-bank financial institutions have diversified risk and brought better market judgment, or created new, hidden concentrations of risks”

Taken from the New Dynamics of Private Markets research series from PGIM.

First look

Ten takeaways from the Europe Summit
With record numbers in attendance, the PDI Europe Summit 2022 in London was a great success this week. Here we reflect on some of the defining discussion points, be they encouraging or challenging. You will find further coverage of the event in this week’s Friday Letter as well as in our regular online and offline coverage.

1. A survey from the Alternative Credit Council showed that more than half of asset class respondents were “cautiously optimistic” despite the various macroeconomic headwinds, while more than 30 percent were “bullish” and only 17 percent “defensive”. It also revealed that Europe, despite its current problems, was viewed as having the highest private debt growth potential over the next one to three years – ahead of Asia-Pacific in second and the US third.

2. After the deals boom of last year, private debt continued to see strong activity in the first half of this year, though it has slowed since summer. There is still appetite to lend, but on a highly selective basis, with club deals more common and average cheque sizes lower. One panellist estimated that M&A activity is 30 percent down on this time last year.

3. In terms of the existing portfolio, the majority opinion seems to be that it’s a case of “ok for now”. Indeed, some managers say they’re pleasantly surprised by the performance of their portfolios thus far. There is clearly trepidation about the future though, with issues expected to start surfacing by the end of the year and carry on into next year.

4. Some of the concern around portfolio company performance relates to an inability for companies to continue passing on increased costs to customers – something that those present claimed has been successfully done up until now. This appears to have become a challenge over the last quarter and is expected to weaken margins going forward.

5. One panellist cited real-life examples of the stresses and strains within portfolio companies – pointing to a business that has seen average wages in the workforce rise from $18 to $23 an hour at the same time as the delivery time for a component part had increased from three days to three weeks. The point was made that capital expenditure requirements at portfolio companies are going up – will that additional capex requirement be readily available?

6. At the same time as lenders noted with optimism the apparent shift to more favourable documentation, they also acknowledged the problems that may have been created by an environment in which covenants have been lessened – or in some cases eliminated – in tandem with leverage reaching uncomfortably high levels. The period ahead will reveal the consequences of what has up to now been a strongly borrower-friendly environment.

7. Views may be changing around favoured sectors, with those that have been viewed as safe even during the covid period now looking rather more unpredictable. One panellist noted challenges faced by the highly favoured healthcare sector, for example, especially in relation to staff shortages. The same panellist said they were looking instead with keen interest at transport and logistics in areas that could help ease supply chain issues, such as fleet leasing and last-mile delivery.

8. Meanwhile, the so-called bank fightback against funds came under scrutiny. Although some famous banking names have been re-emerging in the market, these are really the asset management arms of banks and have institutional investors, just like funds. No one is predicting a rush of banks willing to take big holds on their balance sheets. But – as a perceived shift takes place towards separately managed accounts and perpetual vehicles, and also in favour of organisations able to provide a one-stop-shop approach – the ‘banks’ have reasons to feel well positioned.

9. In a sign of the times, new hires with restructuring experience are in fashion as managers attempt to get in front of the problems emerging in portfolio companies. For pan-European managers this is especially significant given the wide variety of legal regimes in the region and the specialist skill sets required for each of them.

10. In today’s market, complexity carries a premium. Among the favoured investment areas are the likes of speciality finance, together with structured and opportunistic credit. While there is caution – and concern at how high default rates may rise – many perceive pockets of opportunity.

Essentials

Rating weak links on the rise
The number of weakest links recorded by S&P Global Ratings increased to 220 as of September 15 2022, from 202 in July, according to a new report (log-in required). The increase stemmed from a rise in downgrades to ‘B-‘ and a slowdown in upgrades from ‘B-‘.

Weakest links are issuers rated ‘B-‘ or lower with negative rating outlooks or ratings on CreditWatch with negative implications.

Weakest links as a percentage of total speculative-grade (‘BB+’ or lower) issuers increased to 9.1 percent, the highest level since August 2021. The negative bias (the proportion of ratings with negative outlooks or CreditWatch negative implications) for issuers rated ‘B-‘ or lower also ticked up in this period, to 11 percent from 10 percent.

“Weakest link default rates are on average 8x higher than overall speculative-grade default rates, so we could also see an increasing number of defaults ahead,” said Nicole Serino of S&P Global Credit Markets Research.

While rising again, weakest links remain below five-year averages in most regions except Europe.

FIRSTavenue bolsters credit capability
FIRSTavenue, the global placement and advisory firm, has hired John Linger as a senior adviser to focus primarily on real estate private credit, and Jason Melser as a director responsible for private credit marketing and origination in the firm’s New York office.

Linger was previously a managing director with Prospect Avenue Partners, a boutique placement firm in the US focused on real assets. Before that, he led global capital formation for Square Mile Capital, Cherokee Investment Partners and the real estate private equity group at Lehman Brothers.

Melser joins the firm from Bridgepoint where he led the business development and capital formation effort in North America. Earlier, he spent seven years at CVC as vice-president of business development and capital origination.

LP watch

Institution: Texas Municipal Retirement System 
Headquarters: Austin, US
AUM: $35.19 billion
Allocation to alternatives: 38.27%

Texas Municipal Retirement System has committed $250 million to Pemberton Strategic Credit Opportunities Fund III with an additional $50 million as a co-investment, according to materials from its board of trustees meeting earlier this month.

Pemberton Strategic Credit Opportunities Fund III is primarily focused on credit opportunities in Europe by providing junior capital to performing companies to enable expansion or acquisitions. This continues TMRS’s relationship with Pemberton Asset Management, with the pension having previously committed $250 million to the fund’s predecessor in August 2021.

TMRS’s recent commitments have tended to focus on funds that target the corporate sector, while having some investments in Europe.

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