Characterising the current mood of the US credit markets is no easy task. That fateful day on 21 January when a man in Washington State was diagnosed as having the first case of covid-19 in the US unleashed a series of economic shocks in the country that will have profound consequences for its private debt sector. The macro picture will be the starting point for any assessments.

As Michael Ewald, global head of private credit at Bain Capital Credit says, the economic fallout is widespread, with “most businesses” across the world impacted by the pandemic. Yet there are big variations, depending on the nature and type of company.

“More defensive companies across the technology, software and telecommunications sectors have held up relatively well,” he says. “More cyclical companies, including sectors such as retail, travel, leisure, energy, have exhibited a greater impact.”

Ted Koenig, president and chief executive of Monroe Capital, agrees with this sector assessment and says portfolio management will be critical in the months ahead.

“If you are in cloud-based services or tech, your business is doing well,” he says. “On the other side, restaurants, hospitality, oil and gas, metals and mining, and airlines are very much at risk.”

Where credit’s due

The credit markets are set to play a central role in how this downturn plays out. For businesses with operations significantly affected by the coronavirus, borrowing has become the go-to option. For investors, this has presented plenty of opportunities.

Figures from PitchBook show a rise in the number of dedicated distressed and special situations funds coming to market in the first half of 2020. These included US-domiciled vehicles such as the Oaktree Opportunities Fund XI, the Centerbridge Special Credit Partners IV and the Fortress Credit Opportunities Fund V.

Matthew Potter, a partner at Pollen Street Capital, describes this “rush to distressed” as “inevitable”, adding that speciality finance – or lending to lenders – is also looking like a good opportunity.

“The valuation of your loan is a subjective exercise that requires strong knowledge of secular headwinds and tailwinds”
Raelan Lambert

“How a lender managed through the first wave is illustrative of their process, and future impacts to the borrowers can be underwritten,” he says. “Our focus is on the same core strategy and using the initial wave to push for even more robust structures and stronger covenants.”

One noticeable trend in the first half of the year was the significant fall in private debt fundraising around the world, in terms of both capital raised and the number of funds. PDI data show $63.1 billion in capital raised in the same period across 81 vehicles, compared with $79.9 billion across 135 vehicles for the previous six months.

Despite fundraisings dropping considerably, the pandemic has further stimulated appetite for corporate borrowing. While numerous investment-grade companies have tapped public markets for additional funds, private debt providers have also seen a substantial rise in activity.

“There is a fair amount of rescue financing where companies need capital,” says Koenig. “Opportunistic financing has also been popular.”

He explains that corporate borrowing demand directly related to the pandemic has increased the appetite for asset-based lending, litigation finance, bridging loans and other real estate lending.

From an investor perspective, he says that private credit rescue capital continues to offer “good risk-return dynamics” along with the aforementioned opportunistic credit opportunity.

He adds that it may be worth considering non-sponsored transactions: “Any time you go through a dislocation in the market, the non-sponsored transactions tend to be more interesting because you are advancing at lower leverage and at much better interest rates and fees.”

The observations by Monroe’s CEO are echoed by others. Raelan Lambert, partner and global head of alternatives at Mercer, explains that additional opportunities in distressed debt, and to provide asset-based lending facilities, rescue financings and solution capital, may emerge if defaults spike further – especially given the abundance of covenant-lite debt in the market.

“There may also be the opportunity to get some equity upside as a part of that,” she adds. “This could generate much stronger yields and total returns.

“Obviously, if companies are in trouble, there is a cost to financing them. You may see refinancing activity slow, particularly in the broadly syndicated markets, providing opportunities for private lenders to step in.”

Yield drought persisting

The opportunity to generate stronger yields will be music to the ears of investors.

In March, the Federal Reserve – like many central banks – cut the US benchmark interest rate to zero and announced another programme of quantitative easing. Its portfolio of long-term securities grew from $3.7 trillion to $6.2 trillion between 2 January and 30 July.

For investors seeking yield, government bonds no longer hold the attraction they once did, with duration risk tarnishing the appeal. There has been a realisation among institutional investors that they may need to take more risk if they are to meet their liabilities.

“It is never good to have prolonged low interest rates,” says Koenig. “Whether it is state pension funds or city pension funds, everyone needs to get a certain level of return. When the prolonged government yield is very low, it will force investors to take more risk.”

Consultants say this ultra-low yield environment is already fuelling demand from clients for US private debt.

“We believe managers who have been positioning their portfolios with a late-minded cycle view will be able to better navigate periods of volatility and disruption”
Michael Ewald
Bain Capital Credit

“We have seen tremendous demand,” says Lambert. “There are a great many clients where private debt is no longer a niche asset class. The appeal is simple: they can look to private debt for a sustainable income stream, which allows them to achieve their investment objectives.”

Mercer’s global head of alternatives explains that appetite for opportunistic strategies is insatiable at present.

“For clients implementing directly, through opportunistic strategies, we are seeing allocations going from zero to 5 or even 10 percent,” she says.

Despite this, Michael Ewald, global head of private credit at Bain Capital Credit, warns that investors with higher liquidity demand may halt allocations to private debt in the months ahead.

“For LPs with a need for ongoing liquidity to match their liabilities, we would expect to see a pull-back for new investment allocations to private debt,” he says. “Cashflow across illiquid investments is expected to slow down, given lower prepayment-related activity.”

Ewald adds that the ongoing travel disruption may further impact investors’ ability to conduct due diligence in person, which could reduce their ability to invest in new platforms.

Despite this, he believes strong pre-existing relationships could prove useful in the months ahead: “We may see an increasing trend of new allocations to private debt come from LPs with pre-existing relationships with GPs given a higher focus on a longer length of track record and history with existing managers.”

Under the microscope

The consensus among the investor community is that manager track records will become particularly important in any new allocations in the coming months and years. Lambert believes that those with experience of navigating through previous downturns will be at an advantage.

“I do think that managers that have invested across a few cycles know which rocks to look under and are better positioned to anticipate where they can get burned. Private debt requires company-level diligence in addition to strong credit structuring skills. If you get the business model wrong, even a perfect deal structure will do no good,” she says.
“The valuation of your loan is a subjective exercise that requires strong knowledge of secular headwinds and tailwinds as well as a keen understanding of business fundamentals.”

Ewald expects private debt to see an increase in amendment activity for the remainder of 2020, along with a higher level of defaults. For this reason, he believes it will be critical to look closely at portfolio positioning: “We believe managers who have been positioning their portfolios with a late-minded cycle view will be able to better navigate periods of volatility and disruption ahead.”

Although industry experts appear to agree that managers with a history of managing through tricky economic periods are at an advantage, Lambert believes there is also scope to recognise managers that do not fit this bill entirely and whose skills lie in specialist areas.

“We are not turning a blind eye to teams who have spun out of the well-established managers, to focus on more niche opportunities,” she adds.

Potential for performance

In the years following previous downturns, credit markets have traditionally performed well, according to data from FE Analytics. Between 31 December 2008 and 31 December 2011, the HFRI Credit Index rose by 33.1 percent.

Koenig expects 2020-22 to be a similar period of favourable performance, particularly for US private credit: “Every time we had some dislocation, the next vintage for private credit has performed very well.”

He cites economic downturns in the 1990s, the bursting of the dotcom bubble and the global financial crisis as examples of recessions which were precursors to periods of good performance.

“I am very bullish on the 2020-21 vintage of US private credit,” he says. “The risk-adjusted return metrics have gotten better. We are getting better pricing and lower leverage.”