Sep 27, 2022

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.

 

As an LP in private funds for a MFO, PC has terrified me for a few years now as PC is marketed as "low risk, enhanced FI" which it's not...It's more or less correlated to PE deals performing and if rates go up (which they have and will likely continue to do so) many of these companies are going to have issues from being overleveraged by the sponsors. . Another note is there's been a massive influx of capital coming into this space, especially from HNW/UHNW. BRCED, BX's quasi-liquid BDC has a $50b FMV after just ~18 months of being seeded with every $ in it being individual capital. The second brokers/clients start hitting the exits on these sort of funds they're done.

  8.3.4
 

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

 
PF_Leverage

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

I don't think 8-10% yield is what direct lending funds target. They are levered and target equity-like returns. Liquidity will be a real issue though. 

 
Most Helpful

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)

 

I'm curious how direct lenders will be able to compete at more senior levels of the capital structure though - their value-add has always seemed to me to be being able to invest at more junior levels to fill the gap where your traditional banks aren't able to stomach the risk. Once you start having to fight for senior secured loans, it's going to be hard to get the kind of returns private credit funds are looking for, and besides you aren't going to be able to offer terms that are as competitive as banks who have a much lower cost of capital.

Just started on a levfin desk so would be really great to get some insights in this area.

 

Their value add is willingness to take more risk. Banks, by choice, by business model and by regulation, cannot engage in as risky of lending. Yes, as you point out, sometimes that is going down the cap stack. Sometimes (a lot of times) it is letting a sponsor put 6.0x on a business a bank would put 3.0x times on. Private credit is also more likely to have more favorable covenants. There is more risk here, but you can also charge a higher rate.

On the point of returns, many credit funds use leverage from commercial banks to amplify their returns (i.e., how you get from SOFR+450 to a fund return of 9%, illustratively). There is refinance risk if the tenor of the CB loans are shorter than the tenor of your loans youre funding, but that can be managed.

 

I think they’re referring to cash interest costs going a lot higher for these already highly levered borrowers. If liquid credit (HY, lev loans) in larger and relatively less risky credits can get you 8-10%, the value prop of private credit is somewhat diminished.

 

What you're really asking is will PE survive bc its dependent on credit, whether from direct lenders or HY/LL. For direct lending to be crushed means that PE in general is crushed. I think what is more likely to happen is that direct lending will survive because it offers sponsors some attractive aspects relative to the public HY/LL markets. Though some LPs will realize that its likely just a volatile as the traditional LL space. There will be some credit losses and some smaller less diversified direct lenders might fair much worse. But overall I don't expect some horrible outcome...maybe just some leveling / retraction of the hyper growth. 

 

Also, I'd like to add that by implying DL could implode its also implying that the LL mkt, CLOs and HY implode too. DL is just a fungible credit option, its not like deals are way worse than in the public mkts. Much smaller DL funds could be hit more of course, but I'm more so talking the larger deals that have been stealing share from the public mkt space. 

 

Very insightful post. I saw someone had mentioned BlackRock on here and I had recently interviewed for US Private Credit. 

I had asked some questions about current market conditions relating to the rates they have on issued private debt and so on (very important as it can directly affect their business). As you'd imagine, they had already planned for this and have a structure currently that would actually benefit them. 

That being said, I do agree with OP that there was a LOAD of LBO'd business very recently and it will be interesting nonetheless to see how a lot of these businesses will handle it going forth. However, I do see PC still expanding much further with estimates into the 2T+ by 2023 and therefore positioning it as a top private capital class. 

 

This was a Junior SA role so ideally from here to FT AN. The interview went well, I had to answer some pretty light technicals but nothing too complex. A lot of fit related questions and more structured as a dialogue. 

Also, I read through some of your posts on the thread, very helpful! If you have any sources for younger professionals to learn more about the PC space (technically speaking) I'd be happy to give a read.

 

what exactly do you mean by "benefit them" is it just the floating rate is good in a rising rate environment thing that everyone says while ignoring the underlying issue of rising rates/inflation/lower demand for the business? 

That said BlackRock US Private Credit does have a distressed debt heritage from Tennenbaum, so even though its not a focus, they know how to successfully work out troubled credits and have had some pretty decent returns (think theoretical target return for the asset class) on their special situations sieves of their Direct Lending Fund IX vintage

 

Exactly like you mentioned with troubled credit, they had mentioned to me a little more on that and having rather good returns. 

 

Following. Just started as an analyst at a bank working in pc- underwriting and syndicating sr. secured debt and most places wont touch deals below sofr+400

 

It’s interesting to see how people who were used to 0% rates for 10 years and couldn’t see this coming are now convinced that a 4-5% FED funds rate will also last that long despite evidence saying otherwise. A few points:

(1) Insurance colonies are by far the largest investors in PC, not pension funds. That’s because regulatory capital penalises volatility and PC mitigates that. Pension funds want higher returns so prefer distressed debt and PE strategies

(2) As someone was saying above, PC differentiates itself vs banks due to higher risk appetite (leverage up). However the main reason why sponsors like PC is certainty of financing, especially in the current market. When a deal has to close, you cannot afford to price at the caps and be stuck with that price because the market is just going crazy. As of today, PC margins remain lower vs public markets.

(3) It is not true that there’s plenty of liquidity until next fundraise. Fundraise happens every 2-3 years and some large funds (some mentioned above) are in the market now for the next vintage. After the market drawdown of FY22, I’m seeing an increasing interest in evergreen structures which are not affected by vintage considerations: will see how this evolves.

(4) It is true that it’s a crazy crowded market. Everyone seems to be opening a PC fund (Fidelity, Pictet, to give 2 recent examples). However, performance in PC all depends on (a) skills acquired by repetitions (ie how many times I’ve seen this business or similar before and if it goes wrong I know how to solve the issue) so large funds do have an edge, and (b) sourcing channels as someone said above: though it is true that advisors will call the whole world, sponsors have direct, personal relationships with some PC funds and not others (mainly funds which have supported them in the past, have not made their life hell for a simple technical doc breach, etc).

So overall I feel very positive for the industry. There will be consolidation at some point (once the new ventures will realise they are sub-scale to sustain fixed costs) but I continue to see flows into PC (as opposed to say HY).

 

Circling back to this thread...realize it's only been ~3-4 months since originally posted, but are we seeing a material credit crunch / uptick in defaults in the PC world? Obviously it's pretty opaque so no clear window, but my understanding is that the industry has held up well thus far AND is in fact one of the only places you can get financing aside from Pro Rata market (which only allows for leverage up to ~3.5x & comes with covenants + need for meaningful equity contribution). I feel like this environment is actually showing the benefits of private credit, and I work in LevFin/Cap Mkts focusing on Pro Rata / TLB / HY solutions...

I've anecdotally heard that hold sizes came in, pricing widened, and covenants tightened, but compare that to the TLB market which has struggled to generate successful new issuance for ~6-9 months for credits below BB rating and it seems the PC asset class is alive & effective. I think if we face a steep recession certainly there's a risk and how exactly do you work out an illiquid LMM / MM credit if there's no PE / PC buyer (though i'm sure there always is...at a price) - I think the savvy investors will have capital available for incremental equity injections as needed to cure covenant issues or provide liquidity as needed, and PC will amenable to that (and may very well have pref equity / coinvest in the mix too).

I also feel one thing that's been overlooked in this thread is the more efficient process in PC vs. the pro rata / syndicated market. As a borrower, you may still get a proctology exam but at least you don't have to subsequently go through ratings process (if institutional issuance) + early look / anchor ticket meetings + lender meeting + multiple lender diligence calls & helping answer diligence questions (unless perhaps you have a clubbed up direct type deal). It's one document if you're doing a PC uni structure too, and would you rather have a close knit relationship with your core lender or have to maintain connectivity with a lead bank + anchor tickets + all the schleps further down in allocations? 

 

Personally, think its a bit earlier to declare victory for PC. I manage a book of leveraged credits and we are starting to see clear signs of what appears to be significant demand pull-forward in 2021 and 1H'22 - I think this, in combination of high rates, will put pressure on PortCos in 2H'23. Interest Rates (SOFR) were still pretty damn low until ~3Q'22

 

I completely agree it’s too early to make that determination and sorry if my comment was unclear / one sided. I expect PortCos will face issues and it will be interesting to see how PC responds, and how those responses differ based on AUM / dry powder / borrower scale. 

I guess one of the points I was trying to make is that the ability to get deals done via the PC market held up better thus far despite the rising rates and macro backdrop, whereas the institutional TLB / HY markets were very rough back half of 2022 with conditions shifting fast enough to result in hung deals / steep underwriting losses. 

 

Covenants are drifting into “metric/KPI realm” i.e. not your usual leverage ratios (think avg customer check for a restaurant chain - as an example), and even some negative testing (negative ICR as an example). Pretty nutty, but this is what sticks at the moment.

 

I will say our fund has been FEASTING in this environment. You’re an idiot to not invest in top decile businesses with a tight doc and great pricing. 13%-14% unlevered returns with convexity for borrowers that used to never even get close to the private market (mainly due to size / business quality). Would invest in the right names hand over fist with conviction

 

How much are you deploying and across what sectors? 

 

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