As the economic environment evolves, investors need to change too

Randy Schwimmer

Co-head of senior lending

Churchill Asset Management

Managers will need broad capabilities and multiple sources of funding

Ten years ago, I became a regular contributor to Creditflux. It seems like yesterday — until we reread our debut submission. Back in 2014, the Fed, OCC and FDIC were tightening the screws on leveraged loans on bank balance sheets. Only a few years removed from the great financial crisis, regulators cited “serious deficiencies in underwriting standards and risk management” as heightening systemic risk.

Since then, bank involvement in risky loans has declined precipitously. Non-banks have gained a dominant share in buyout financings, particularly in the middle market. When the zero-for-longer decade ended with the Fed’s intense anti-inflation campaign, liquidity drained, not just from the economy, but from bank reserves, trading desks, CLO formation and retail fund flows. The higher rate macro pushed public credit offline, tilting buyout financings in favour of direct lenders.

Fuelled by appetite from institutional investors seeking higher premiums, better protection and tighter terms — as well as the consistent returns afforded by less correlated assets — the largest private debt managers with the best track records raised enough capital to commit and hold entire financings. This allowed private equity sponsors to obtain no-outs term sheets, avoiding lengthy syndication processes. By not having to distribute the debt, managers also provided price certainty to issuers with no market flex.

In turn, top financing shops could deploy enough dry powder to satisfy growing investor demand, allocating across multiple internal funds so no single vehicle held concentrated risk. As private debt fundraising ramped up, firms embarked on an arms race to capture mega-deals formerly destined for bank/bond executions, building enough capacity to hold USD 1bn or more per transaction.

Identifying the best private capital managers

Looking to the future, macro pressures are creating intriguing dispersion effects among private capital asset managers, private equity firms and portfolio companies. As we navigate the risk of a slowing economy, volatility and geopolitical shocks on the market, investors need to identify key attributes of haves and have-nots.

Large managers with broad investment capabilities, multiple sources of dry powder and sustainable deal-sourcing will thrive. They can secure the highest-quality deals, build all-weather portfolios and attract the most diverse capital base, fostering resilience in any market cycle.

Private equity firms with ample funds and a proven track record of valuation discipline will prevail as the buyer of choice for the best investment opportunities. These firms will adapt quickly to the new normal for rates, developing multi-dimensional value creation plans not solely reliant on financial engineering for growth.

At the same time, portfolio companies adopting prudent balance sheet structures and financing strategies offering payment-in-kind flexibility will be best suited to pursue organic and M&A growth. Platform diversification will protect and enhance profitability and cashflow generation — which are especially valuable in a high rate environment. A private equity allocator that is active in equity co-investments, for example, can toggle there when LP distribution wanes, as it did last year.

Small firms may be sidelined

Conversely, asset managers lacking scale, comprehensive capabilities or differentiated deal origination, face significant hurdles, and may find themselves on the sidelines in a slower deal environment. Similarly, private equity firms lacking sufficient dry powder, ability to raise new or larger funds, or valuation discipline, will fall short in competitive processes where value-added partnerships count most. Meanwhile, portfolio companies with aggressive capital structures and higher cash interest burdens will be forced to shift available cash to debt service, compromising growth initiatives while retaining little cushion to endure economic turbulence.

As a result, dispersion across market participants will be a pivotal investment consideration in the years ahead. Gone are the days of hiding in the middle. Mediocre performers are at risk of slipping into the have-not camp. In a period unlikely to return to zero-for-longer, the best private credit practitioners — those which embrace scale, cultivate diverse capabilities, lead with true sourcing advantages, exercise valuation discipline, and maintain conservative and flexible balance sheet structures — will represent the future of buyout financings in the decade ahead.

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