Private Credit - Will it Hold Up?
Curious what people's thoughts are on Private Credit performance in a downturn - realize thoughts likely will vary based on how bad the downturn gets.
Many of these shops were putting 5.5x-7x leverage on companies the last year or two with SOFR/LIBOR being at ~0% - I find it hard to believe hardly any of them thought SOFR would get to 3-4% in such short order, effectively increasing interest expense anywhere from say ~50% - 100%. I'd have to imagine there's going to be a good chunk of these companies with a near ~1x Interest Coverage ratio as a result in 2023 (or less).
I think it goes without saying that there's a lot of business that got LBO'd at/near peak performance (whether it be a COVID bump, benefitting from the booming economy in general etc.) which could put further pressure on coverage ratios i.e., a double whammy.
Icing on the cake? A lot of deals issued in the private credit market in the last year seem to have little protection from a documentation standpoint (cov. lite etc.) meaning shit could theoretically be really bad at a given portco prior to the lender being able to step in which reduces recovery rates.
Lmao yes some folks are going to get burned on those cov-lite 6.75x unis for Vista they did last year
The direct Lending model does not work at these rate levels IMO. Allocations to private credit were built on a Low Rate environment world, why is a pension fund going to pay fees for an 8-10% yield when they can buy treasuries at 4%? My guess is the risk in private credit is much bigger than people think as it's correlated to Private Equity. PE funding goes down and all of a sudden private credit is stuck with names where this no exit liquidity ( ie takeout by a different PE firm). Most of those credits are too small to get regular way debt (HY/TLB) or too levered because they were underwriting on equity value/cushion. Also, I'm assuming most issuers/credit didn't cap their interest rate so most must be feeling pressure on their interest coverage.
Perhaps, the dry powder/liquidity out there is enough to stall the storm, but if Treasuries are still in the 3-4% range next year I bet it gets ugly
It’s all relative. As treasury yields go up, so will private credit yields.
My view is it will survive. Might be tough but it will survive. If you’re a lender sitting on a mountain of covlite 2L paper I don’t know what to tell you.
Floating rates will strain a lot of companies, but there’s room to give because ending up in a workout isn’t in anyone’s best interest. There’s been a push up the cap stack to senior sec in direct lending which will help vs. when direct lenders loved going down the stack.
On the fundraising part, the funds are already sitting on boatloads of capital that is illiquid, so there’s time before they need to fundraise again. And, in any event there have been massive fundraises and pension funds announcing that they are allocating more capital to private credit and equity.
The real pressure is going to be market crowding. Every fund and asset manager has a private credit fund now. A few few differentiators come to mind:
(a) having multiple strategies (e.g., direct lending, special situations, structured equity, etc.) allows for more opportunity to find good deals vs. just one strategy. When the market’s hot your direct lending team is on fire, and when the market’s down your opportunistic credit team is finding toeholds. And I see the separate teams that bigger investors have as potentially having advantages from team focus vs. one team for all strategies.
(b) pricing power will matter more — if you’re L Catterton’s brand new credit fund, you’re going to get beat up on rates; however, if you’re BX dropping in a $400M uni you’re getting more pricing power (try negotiating anything with Goldman — it’s not fun)
(c) having novel channels to source deals will be very valuable vs. being someone on the list every fund calls (e.g., BlackRock and Carlyle’s credit funds can use the entire organization to source deals from all the areas they have their tentacles in vs. a Maranon)