Record levels of inflation were the big story in 2022 as companies grappled with the impact of rising labour and energy costs alongside supply chain challenges. As the rate of price increases moved into double digits, hitting 40-year highs in many major economies, central banks responded with interest rates hikes that wrought further challenges on private credit portfolios.

The International Monetary Fund predicts global inflation will fall from 8.8 percent in 2022 to 6.6 percent in 2023 and 4.3 percent in 2024, remaining above pre-pandemic levels for the foreseeable future. For lenders, such rapidly escalating cost bases bring new dynamics to both assessing deals and managing portfolios.

Thierry Vallière, head of private debt at Paris-based fund manager Amundi, says: “On new transactions it is easier to deal with inflation risk because it is about your own assessment of what will be the consequences of inflation on the business. That comes down to whether the company has the capacity to pass all or part of the inflation of raw materials and energy on to the final consumer, and then it is a matter of conviction.

“There are certainly some companies that we would have looked at before where we now need more clarity on how inflation will fall for the next two or three years.”

Turning to existing deals in the portfolio, Vallière says Amundi twice assessed its portfolio last year on the impact of inflation and the capacity to pass that on. “We have 130 companies in our portfolio and we undertook quite an intensive assessment,” he says. “We are now closely monitoring just five or 10 of our companies that might need some additional financing, additional support from sponsors or additional liquidity because they are facing a major impact of energy costs. No one foresaw the current crisis but we do tend to invest in less cyclical sectors and companies with high barriers to entry and pricing power. As such, it is not a surprise that the impact is not widespread.”

Sticking with resilience

The vast majority of direct lenders have taken a similar approach to favouring resilient businesses with the ability to pass on cost inflation, so the asset class looks well placed to ride an inflationary storm.

Eric Capp, partner and co-head of direct lending at European mid-market specialist Pemberton Asset Management, says: “For companies that are dependent on commodity prices or low-wage labour, those input prices have been increasing over the last few years as we emerged from covid. The good news is for companies with leading market positions in growing industries where the capacity is tight – it is much easier to pass those costs through and grow EBITDA while maintaining margins.”

Capp says the largest portion of Pemberton’s direct lending portfolio is in companies that provide essential goods or services, which are more resilient to these types of inflationary forces. 

“For those companies which are impacted by inflation, the management teams have to be really focused on price pass through, looking at their contracts with customers and having more contractual mechanisms to pass-through inflation in commodities, wages and energy,” he says. “Trying to build in mechanisms to reduce the lag between input prices going up and the price you charge the customer is key.”

Ed Testerman, partner at New York-based King Street Capital Management, says the lag in passing through inflationary cost pressures is creating a distressed opportunity for certain lenders. “The sector that we are spending the most time on right now is healthcare services, which might surprise people because healthcare is traditionally thought of as non-cyclical or countercyclical,” he says. 

“What has happened is there has been a fairly significant labour shortage for healthcare providers, and many of those providers are ultimately reimbursed by the government. There is oftentimes a lag in government reimbursement to offset significant cost inflation.

“That creates a temporary divergence between where costs are for those businesses and where pricing ultimately comes in. That lag can take 12 to 24 months, so those healthcare service providers have seen their margins decimated, which presents an opportunity to fund a secularly growing segment of the healthcare ecosystem in navigating a temporary issue.”

Margin compression

At Partners Group, global head of private debt Andrew Bellis says margin compression is the biggest challenge for direct lenders. “We still see broadly across the portfolio that we have good top-line growth but margins are under pressure primarily due to cost inflation. There is not a consistent trend in terms of inflation impacting every business in the same way, so it depends company by company on how they are managing through, both in terms of passing costs on and flexing their cost base.”

He says the ability to support businesses through their own esoteric issues will play to the strengths of direct lenders. “Yes, there will be increased levels of stress and increased levels of default across the market,” says Bellis. “You have to do your due diligence, do proper credit work and be robust about how you work out situations in your portfolio. Direct lenders will differentiate themselves and those that stand out will be the ones able to support portfolio companies on this.”

Some predict that as 2023 progresses, the worst of the inflationary pressure should pass. Claire Harwood, managing director at Permira Credit, says: “Inflation splits into two parts, the core inflation around food and people costs and the other element around energy. Last year, roughly 45 percent of inflation was down to energy costs, and those are now fully under control in the wholesale market, so we are likely to see inflation coming down.”

Daniel Hatcher, also at Permira Credit, adds: “Management teams face execution risk here, in that they need to take a targeted response to inflation. The well-managed companies are the ones that already had hedging in place, and it now comes down to their ability to navigate through.”