The clouds hanging over the asset class

An age-old contrary indicator in the public markets posits that by the time a trend has made it to the cover of a magazine, it’s as good as over. 

What with the recent ballyhoo by asset manager luminaries singing the praises of private debt on television and earnings calls, one could be forgiven for wondering whether the same concept isn’t at play with the asset class. “Now that we’re in the ‘golden age’ of private credit, it makes me nervous about what’s about to go wrong,” were the approximate words of a panellist at Private Debt Investor’s New York Forum in September.

It is understandable that managers on the fundraising trail will invariably extol the virtues of private debt. “There are a lot of tailwinds, including an increasingly sophisticated institutional investor base and the expansion of the asset class to retail investors,” says Jeff Levin, co-head of Morgan Stanley’s North America private credit team and head of direct lending. Because terms are now favouring lenders originating loans, he and others believe “the 2023 vintage will be among the best we’ve seen”.  

Chris Wright, head of private markets and a managing director at Crescent Capital Group, echoes the sentiment. “With the growing awareness that borrowers are facing a maturity wall starting in 2025, we’ve begun to see a real opportunity for private credit,” he says. “You’re seeing seasoned public issuers come to the private markets for certainty of execution in the face of volatile syndicated markets.” Case in point: the leading role of Oak Hill Advisors and others in the $5.3 billion financing of Finastra in September, the largest US private credit transaction to date. 

But some managers are voicing concerns. While we certainly aren’t saying, as another panellist at the forum bluntly put it, that “the shit is about to hit the fan”, there are a few concerns to keep a look out for, as we suggested in our May cover story.

“We are in a period of low credit availability and a high cost of capital, a very unusual scenario that hasn’t occurred in the past 10 years,” says Arif Bhalwani, a founder and chief executive officer of Third Eye Capital, a Canadian capital solutions provider. Although many private debt firms excel at financial engineering, they are not really operators, he says. “If they suddenly need to get hands-on, it’s like asking the deck hands to captain the vessel; they’re not going to know what to do.”

To identify the most pressing concerns, we canvassed a number of market participants and observers, and arrived at the following five areas that represent significant threats to private debt’s ‘golden moment’. 

1

Interest rates

The Federal Reserve and other central banks have tightened interest rates at the fastest pace in a generation to combat inflation. In just 18 months, the Fed’s benchmark short-term rate has jumped by more than 500 basis points to a range of 5.25-5.50 percent, its highest level in 22 years. 

“The confluence of higher for longer and the velocity by which the regime has shifted will create dispersion,” says Amanda Lynam, head of macro credit research at BlackRock. She believes the higher cost of capital will lead to “a more healthy flushing out” from the easy money years where “weakness in fundamentals can get masked”. However, she notes that companies have paid down debt, providing a powerful offset to the spike in rates, and that many have entered this period from a position of strength.

Nevertheless, older vintages that need to be refinanced are likely to be challenged. For the 2021 vintage, an era of highly levered, unhedged deals, “no one saw the rate environment changing that dramatically, and as a result got caught off guard” when the Fed started tightening in March 2022, says Blair Faulstich, a senior portfolio manager at Benefit Street Partners. Since then, the cost of capital has surged to 11 or 12 percent from 6.5-7 percent. One private debt manager put the increase in interest burden resulting from the tightening at a whopping $7 trillion. 

‘Slow-moving tsunami’

“Trillions of dollars of deals done in a zero-percent interest rate environment could lead to a tough cycle ahead, from the manufacturing recession that is underway, to the slow-moving tsunami that is coming to the commercial real estate world, to the complex challenges facing Europe,” says Victor Khosla, founder and chief investment officer of Strategic Value Partners, a distressed debt and deep value manager.

Indeed, Starwood Capital Group’s chairman, Barry Sternlicht, told The Carlyle Group’s David Rubenstein in a Bloomberg interview this summer that the tightening has produced “a Category 5 hurricane”, with commercial real estate being “collateral damage” in the Fed’s effort to curb inflation.

Because the rate increases have yet to work their way entirely through the system, “we will be in for a longer slog than people expect,” says Ashwin Krishnan, co-head of Morgan Stanley’s North America private credit team and head of opportunistic credit. If rates continue to stay high, this time next year “there will be significant pressure on portfolios”, he says. 

“Trillions of dollars of deals done in a zero-percent interest rate environment could lead to a tough cycle ahead” 

Victor Khosla,
Strategic Value Partners

“As loans mature, and they have to be refinanced in a meaningfully higher rate environment, there will be stress,” says Armen Panossian, a managing director and head of performing credit at Oaktree, where he will become co-CEO early next year. This summer, Moody’s predicted that interest coverage ratios will drop below one by the end of this year for 188 US corporate bond issuers rated B3, more than double that of the year earlier period. 

“I don’t mean to be alarmist, but I think the worst is yet to come,” Panossian says, noting that Oaktree is one of the major providers of capital solutions. 

But “higher for longer” rates is not the only concern. “The inversion of the yield curve is something we are watching very closely,” says Joel Holsinger, partner and co-head of alternative credit at Ares. That’s because the yield curve inversion “creates a lot of ripples through all industries and asset classes”. 

The issue is that loan originators need to warehouse loans at higher rates than they’ll eventually get when floating rates reset. “The thing that guarantees a credit contraction is an extended inversion of the yield curve, and we do expect it.”

2

A credit crunch

Banks already have been pulling back on their lending, with the Fed’s Senior Loan Officer Opinion Survey on Bank Lending Practices for Q2 showing that US banks continued to tighten underwriting standards across all commercial and consumer loan categories, which often presages a credit contraction. David Rosenberg, chief economist and strategist of Rosenberg Research, says “there is no better indicator” than this survey to predict the credit cycle. Rosenberg also has noted that the Dallas Fed’s banking conditions survey for August showed credit had continued to contract. 

Others agree. “We have not had the credit cycle yet, and when it comes, it’s going to be a lot worse for those that don’t have liquidity and funding to hold their distressed positions,” says Charles Peabody, a founding partner and president of independent bank research firm Portales Partners, who raised red flags about some regional banks before they started imploding earlier this year. 

Peabody thinks the losses outside the banking system will be greater than inside because of the lack of stable funding. “Non-banks are taking up the risk banks are unwilling to take, and those that take market share at the end of a cycle are typically the ones who have the worst experience during the downturn. 

“Mark to model and mark to myth is what characterises non-bank entities. The big marks are yet to be had, and once the credit cycle takes place it’s likely going to scare investors who will demand withdrawals”. The good news? The gates on funds will slow the process. 

Is recession still on the cards?

“A material credit contraction could potentially lead to a greater recession,” says Dan Pietrzak, global head of private credit at KKR. The multi-trillion-dollar refinancing wall in US and European commercial real estate is a potential driver. 

“The key to how challenging the cycle will be is how much longer does the yield curve stay inverted?” says Ares’ Holsinger. 

Last summer, there were indications that the credit cycle has worsened, Peabody says, pointing to rising credit card and auto loan defaults, as well the tsunami in the commercial real estate market. He says the other area that does not get much attention is counterparty risk in the financing of other people’s investments, such as funding of financial sponsors with subscription lines of credit and NAV loans, which has risen dramatically in the past five years. 

“When a recession hits and an entity doesn’t have stable sources of funding, the banks financing the asset managers are likely to cut and run,” Peabody says, “leaving the managers and limited partners to take the hit if they have to sell into a distressed market.” Indeed, global financial regulators warned in September that “hidden leverage” in the financial system from a huge build-up of borrowed money among non-bank institutions could stress and disrupt financial markets, pointing to the collapse of Archegos Capital Management in 2021 as an example. 

3

Defaults and bankruptcies

With the added stress on companies’ cashflows created by higher rates, “there will be (and already are) a much higher level of defaults and bankruptcies than during the halcyon years of ultralow interest rates”, says John Henry Lucker, partner and head of structured finance at Catalio Capital Management, a biotech-focused private credit and private equity fund whose backers include Stanley Druckenmiller and Henry Kravis. 

Through August, US corporate bankruptcy filings jumped to 459, exceeding the combined total of the prior two years, according to S&P Global Market Intelligence. Corporate insolvencies in Canada jumped nearly 36 percent for the 12 months ending in June, per government statistics. 

Third Eye’s Bhalwani says he’s noticed a pick-up in formal restructurings and insolvencies, where some newer and less experienced private debt firms are the primary creditors. “In many of these cases, the private debt firms will need to take over the businesses or suffer an immediate loss in liquidation.” 

“There will be a culling of the herd, in terms of managers doing triage around which of their portfolio companies will make the cut and which will fall by the wayside”

John Henry Lucker,
Catalio Capital Management

In his Q1 letter to investors, Bhalwani warned that during periods of financial distress, some parts of the capital stack in a syndicate can fall victim to a “cannibalistic assault” (otherwise known as creditor-on-creditor violence) in resolving the issues. 

Risk assessment

Data and analytics provider Burgiss, in a review late last year of the riskiness of the 23,000 private loans representing $2.23 trillion of value (as of April 2022) that it tracks found that while most loans are “senior” and thus put the debt holder first in line for repayment, “it does not mean that the loan is low risk – the loan could be to an entity with a high credit risk”. In addition, although the median spread between senior and mezzanine loans was 7.9 percent, Burgiss found that “there remains a substantial overlap between the senior and mezzanine loan spreads”. 

Further, recovery rates from bankrupt companies are under pressure, with Bank of America estimating last summer that based on loan prices 30 days after a default, recovery rates were averaging a mere 25 percent. BofA is more sanguine for the long term, predicting a 50 percent recovery rate.  

Bhalwani emphasises the need for lenders to control the terms, amendments, and exercise of remedies in their credit agreements, something that was sorely lacking in the go-go years of the late teens and early 2020s. 

Stressed situations can present “a prisoner’s dilemma”, when sponsors with weak covenants in leveraged loans remove assets and separately capitalise them into a new loan with selected existing lenders, sometimes gaining priority rights at the expense of others, says Dan Zwirn, CEO and CIO of institutional asset manager Arena Investors. 

“Sometimes, separate subsets of investors in a loan work against each other and vie to partner with the company management and the sponsor to extract and separately capitalise the good assets,” he says, adding that many of the large PE managers who have raised new funds are “seeking to monetise assets that are part of the implosion that started in late 2021 while trying to mask blow ups in their own portfolios with ‘amend, extend, and pretend’ deals with their lenders”. 

Oaktree’s Panossian says that even if private equity sponsors have dry powder, they are examining their portfolios and “figuring out which are the ones that need to win”. This is already occurring in the commercial real estate market, where valuations are plummeting and sponsors reluctant to “throw good money after bad” are looking at the possibility of “flipping the keys back to the lenders”, he says. 

Nevertheless, “most lenders do not want to own these businesses; they’d much rather come to a negotiated solution”, says Joseph Weissglass, a managing director at Configure Partners, a mid-market investment advisory and banking firm. 

“There will be a culling of the herd, in terms of managers doing triage around which of their portfolio companies will make the cut and which will fall by the wayside,” says Catalio’s Lucker, adding there will be a dearth of the experienced workout professionals needed to sort through all this. 

Jane Buchan, a retired CEO of PAAMCO, one of the largest hedge fund of funds, is worried that many smaller funds are raising money using data and statistics that reflect the performance of bigger funds with more resources. “What’s their ability to handle situations that aren’t working out according to plan?” she asks. If a larger manager’s deal goes upside down, they can make a phone call and sell it under the radar to a big hedge fund manager. 

“You have to have paper that trades to support the infrastructure,” something that’s lacking in direct lending, she says. Without the infrastructure that exists in the banking system, “to whom are the smaller firms going to sell when something goes wrong?” 

Zwirn points out that a feature of what he calls “the everything bubble” after the GFC was a series of regulatory and industry practices that effectively served to limit price discovery by raising capital requirements for investment dealers, which curbed trading. Regulators restricted hedging of credits by dismantling the majority of the credit derivatives market, he says. “If you can’t short something in a tradable market, by definition, it’s levitating. There is no price discovery.”

4

Macro concerns

“This is the most difficult economy to read in my career,” Benefit Street’s Faulstich says. “We’re still making the bet we will experience a mild recession,” he adds, citing a confluence of events, including the outlook for higher interest rates and weakening of the US consumer.

KKR’s Pietrzak also expects a muted recession, with one of his biggest concerns being whether consumer performance can hold up. With the consumer accounting for 70 percent of GDP, Pietrzak believes an important factor to watch is companies’ ability to support their revenue line items, which theoretically allows them to manage their debt, if a recession hits.

Unemployment jump? 

Also high on Pietrzak’s risk radar? “Many in the market are expecting unemployment to stay low, but if inflation stays above stated targets and you get a handful of months of negative employment news,  consumer confidence is likely to fall”, which could cause a more severe recession.

“Cracks in the labour market” are also top of mind for economist Rosenberg. “We’re seeing a precipitous decline” in job openings in some indicators, he says. “The moment we start to see a drop in the work week, that’s when people will realise we are already in a recession.”

“The moment we start to see a drop in the work week, that’s when people will realise we are already in a recession”

David Rosenberg,
Rosenberg Research

The US economy is not the only worry. “China’s deepening housing problems are spooking investors, as the property crisis threatens to spill over into the broader economy,” said a September note by Monroe Capital. European economies are also slowing, with Germany in a technical recession and the UK on the brink of one.

“We’re not sure if we’ll have a recession, but with higher rates and a slower growing economy, we think that in a year or 18 months, we’re going to be in a swamp that will take a few years to work through,” says SVP’s Khosla. 

5

Regulation

When it comes to regulation, there is a view that private funds have had it too good for too long. So, the SEC’s latest rules, which attempt to protect investors in alternative funds, are received well in some quarters. “I think the rules are actually pretty fair,” says Marcus New, the founder and CEO of InvestX, a leading private equity marketplace. “If you think about the explosion of private products and asset managers over the last decade or two, there really has not been much of a regulatory change.” 

“Getting all those data flows into quarterly statements… that’s going to be pretty burdensome, particularly for smaller and mid-sized private fund advisers”

Greg Larkin,
Goodwin Procter

He thinks there are some broad principles in areas such as duty of care and avoiding conflict that the SEC’s Regulation Best Interest rules have already introduced to the broker dealer market – and there’s no reason why those same principles should not also be applied to private funds. “I think the standards they put in place are expected standards for anyone doing a good job in the industry,” reasons New. 

But not everyone agrees that the latest directives are something to be taken in the industry’s stride. The necessity of producing quarterly statements is questioned by many in an industry where positions are not regularly traded. 

Hitting smaller managers

“Getting all those data flows into quarterly statements – categorising a whole bunch of expenses in different ways that you’ve not done traditionally and getting them out every quarter – that’s going to be pretty burdensome, particularly for smaller and mid-sized private fund advisers which may not have the same kind of infrastructure as the larger ones,” says Greg Larkin, a partner in the financial industry group and private investment funds practice at law firm Goodwin Procter. 

Larkin believes that what underlies the SEC’s latest move is its belief that private fund fees and expenses are too high – and pressure should be applied to bring them down. “They can’t cause it to happen directly, so I think the idea is if we get a lot of disclosure on what people are actually being charged, investors will start negotiating for something better.” 

Initially, there were some doubts as to whether the private funds industry would take action against the SEC or simply accept the new rules and move on. But things became much clearer in September, when a collection of trade bodies including the Managed Funds Association and Alternative Investment Management Association came together to launch a lawsuit. 

Regulation is becoming a greater threat for private debt funds and the wider private markets. They will not accept it without close scrutiny and – if deemed necessary – a fight. 

Additional reporting by Andy Thomson