The struggle to retain favoured status

Investors continue to put their faith in senior debt, despite a more challenging economic backdrop. Robin Blumenthal assesses current market conditions in the US

Senior debt is on a roll, buoyed by a record-setting year for mergers and acquisitions in 2021 and an abundance of dry powder held by private equity sponsors. Although it is unclear how the geopolitical turmoil and the havoc it is creating will affect the market, the momentum coming into this year has been strong.

Private debt fundraising overall came back with a vengeance in 2021, rising to a near record of $248.7 billion, some 35 percent higher than the pandemic-pressured total of $183.9 billion in 2020. Last year, senior debt accounted for 45 percent of the total, far outstripping subordinated/mezzanine debt (29 percent) and distressed debt (18 percent). Among various debt strategies, the top of the capital stack captured its biggest share of the fundraising pie since 2017, when it took in 35 percent of the total, according to Private Debt Investor research.

“The market was very active last year; we had our best year ever across the board,” says Ted Koenig, chairman and chief executive officer of Chicago-based fund manager Monroe Capital. He does not expect any drastic changes, chiefly because earnings of US companies have been strong, helped by greater cost efficiency. Meanwhile, there’s lots of capacity in the debt market, and the transaction market is “very conducive” to doing deals. Given that organic growth is difficult to achieve in scale, “the best way to grow is with add-ons”, he says, which will continue to require financing.

“It was quite the banner year for dealflow among PE sponsors,” says Dylan Cox, head of private markets research at data provider PitchBook. Global M&A activity in 2021 nearly matched the peaks of 2015 and 2017, with deals announced around the world worth $5.1 trillion, according to a KPMG survey of 350 business leaders. The report notes that the US deal market was “particularly hot”, accounting for $2.9 trillion of transactions, a 55 percent increase from $1.9 trillion in 2020, the year that covid struck.

The US market “is where private credit differentiates itself from the public markets – in making direct loans”, says Craig Packer, a co-founder of New York-based fund manager Blue Owl Capital. Although he does not dismiss the stresses in the global financial system, “US direct lending is pretty far removed from it”, he says.

Leveraged lending doubled last year, to $789 billion, with leveraged loans funding M&A soaring to a new high of $331 billion, far outpacing the previous record of $275 billion set in 2018, according to S&P Leveraged Commentary & Data.

Cox expects direct lending activity “to stay quite robust, as long as dealflow continues”. PE sponsors are still eager to deploy their giant cash piles in M&A deals, and direct lending, which finances 80 percent of PE-sponsored transactions, should benefit, says Koenig.

Going public

Given that many of the best private market deals have already been done, PE sponsors are starting to look elsewhere. “There’s a big push on public-to-private transactions,” Koenig says. PE firms are “turning to public companies because they are running out of good deals in the private markets”, he adds, and when they pursue public deals, “they will be coming to the private market for funding”.

But with equity markets coming off a high, and valuations under pressure, investors are becoming more conservative. “If we do have a big correction or a Nasdaq bear market, you’ll see less reaching for yield this year,” says Mike Meyer, partner and head of capital markets at boutique investment bank Union Square Advisors. “Even before the tanks started rolling into Ukraine, risk was being repriced,” he says.

If the global financial situation deteriorates, the balance might shift from the top of the capital stack to distressed or special situations. “You could see some of the bigger credit funds swooping in with all their cash,” Meyer adds.

Meanwhile, central banks are on a path to tighten monetary policy to combat inflation, which could put the brakes on the global economy. “Certainly, a ground war in Europe is causing havoc with the broader commercial debt markets, including public corporate bonds, bank debt and private debt providers,” says Jeffrey Manning, a managing director at New York-based investment banking firm CohnReznick Capital. “With interest rates rising to combat inflation, and bank regulators signalling that after two years it is probably time to manage the portfolio more precisely, I expect more credit-challenged companies will be looking to refinance.”

Already, “debt that was trading a bit above par and was ripe for repricing in February is now trading below par”, a partner at an international law firm says. “Good companies with good fundamentals don’t want to be up for sale now,” he says. “But there is a tonne of capital out there and once things calm down pricing will firm up again.”

Competition for the best deals had been increasing before the war in Ukraine, as many fund managers competed for a shrinking pool of high-quality credits. Market sources say those deals were getting priced at Libor plus 700 basis points for a single-digit EBITDA business.

Strong corporate earnings and the continued recovery from the first year of the pandemic pushed up overall private debt returns to a record 19 percent for the trailing 12 months through the second quarter of 2021, according to PitchBook’s 2021 Annual Global Private Debt Report. Direct lending funds turned in a still-impressive 12.3 percent performance. While much of the returns represent unrealised performance marked to market, PitchBook’s Cox says the results are creating “extremely strong tailwinds for private debt and direct lending”.

Weight of capital

Moreover, although dealflow slowed a bit in the early part of the year, the pipeline is still strong, says Jake Mincemoyer, head of US leveraged finance at law firm Allen & Overy. In the wake of the geopolitical crisis, “syndicated markets are currently very challenging and high yield debt is effectively shut down for now”, he says. Nevertheless, PE and debt funds “have raised a huge amount of money, with more coming into loan funds given the prospect of rising rates”, he adds.

“I don’t see any significant change in investor appetite for either leveraged loans or private credit,” says Randy Schwimmer, co-head of senior lending at New York-based fund manager Churchill Asset Management. “The driving factor will continue to be the attractiveness of floating rate loans and the lower correlation to public strategies.”

Cox agrees: “LPs can’t allocate fast enough, and many are still behind in their allocations.” Furthermore, private debt dry powder has been decreasing, to 2.5 years from 3.6 years in 2018, a sign that GPs are having “relative ease” in deploying capital.

Although capital raised for private debt funds reached a near record in 2021, the number of funds has been nearly cut in half in the past five years, to 230 from 440 in 2017, per PDI data.

That speaks to a growing trend of large-cap deals getting done. “There’s been a seismic shift in the market,” says Blue Owl’s Packer. He notes that Blue Owl looked at more than 40 deals of $1 billion or more last year and expects that to continue in 2022.

Meanwhile, the traditional market for private debt is also expected to remain strong. “The cycle is still interesting if you’re targeting the middle market, and you’ve got the origination capacity to address it,” says Mathieu Chabran, co-founder of Paris-based fund manager Tikehau Capital. “We’re probably at the end of a very active primary private debt market, and starting to develop a secondary market,” he says.

Whatever the case, “there’s a lot of money that needs to be put to work in 2022”, says Mincemoyer. Although this year will likely be slower, he expects it will still be a strong one for deal activity.