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February 2023 | Issue 252
Opinion Direct lending

Conditions making deal financing challenging for issuers can harm beneficial terms for investors

Randy Schwimmer
Co-head of senior lending Churchill Asset Management
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Direct lending terms look better than at any point in the past decade. But is there enough to go around?
In October a senior portfolio manager of a global asset manager said: “There is a regime change underway. In the previous regime, risk-taking was rewarded.” Last week another capital markets veteran said: “If you liked private credit before, you’ll really like it now.”
These two quotes nicely capture the position investors find themselves in as we open 2023. Thanks to the US Fed’s determined rate push in its battle against non-transitory inflation, the world is more worried about downturns than reaching for yield. In the zero-gravity rate regime before and during covid, risk-taking was rewarded. Now it is punished if not appropriately managed. The question for private credit investors is, can you be rewarded while managing today’s level of greater risk?
In a nutshell, the Fed’s withdrawal of systemic capital and relentless rate hikes, plus the flight of cash from liquid credit, has opened a window of opportunity. But as is often the case, the same conditions making deal financing challenging for credit issuers can prevent investors benefiting from better terms because of rising default rates as borrowers struggle to meet interest payments.
The current credit vintage, which sports lower leverage, tighter structures and wider pricing, is significantly more investor-friendly than anything over the past decade. Not since 2010 have we seen 10-12% yields for traditional middle market senior debt. If the Fed’s hiking plan this year brings the benchmark rate much beyond the anticipated 5-5.5% range, it could have a chilling effect on buyouts.
Direct loan activity will continue to slow
Attendees of our recent webinar with top middle market investment bankers heard how issuers in tough, cyclical sectors, which don’t need to face the debt market, could elect to wait until conditions improve. Deal statistics show direct loan activity slowing. We suspect that trend will continue through the first half of the year until there’s more visibility on the likelihood of a recession.
Much depends on how private credit managers want to play things for the first quarter. Most enjoyed strong returns in 2022, including higher arranger fees, without compromising credit or hold levels. There’s every reason to be cautious when there’s so little visibility on how hikes and QT will unfold, let alone debt limit negotiations amid political manoeuvring.
Deal flow might rest in PE firms’ hands
Much depends on how much dry powder private equity firms have to play with this year. The velocity of investing and realisations has contracted. Some buyers are pencils down, believing market multiples will retreat, improving investment opportunities down the road. Others have a long-developed conviction around M&A strategies with select businesses expected to perform through every business cycle. Nevertheless, even top-tier firms expect fundraising to be more difficult than in prior years.
Experienced private credit managers have seen this movie before. A large, diversified client base and portfolio keep deals flowing regardless of buying sentiment, and allow investors to benefit from uninterrupted deployment and allocations. It also means they will enjoy the better yields and structures in the current market.
Refinancing activity has ground to a halt. The lack of repayments suppresses lender dry powder — not necessarily a bad thing for top managers with significant new credit capacity. Add-on financings are up as sponsors seek ways to build existing platforms in lieu of new buyouts.
With rates rising, average hold periods for direct loans (now two-to-three years) should lengthen. What are the implications of that trend? Duration risk is still modest compared with fixed income. But moving the needle on average yields and leverage in a large, diversified portfolio takes time. It also becomes tougher to trade into other strategies, sectors or assets.
Nevertheless, the next few quarters will be highly constructive for private credit investors. Scarce assets are more highly valued. The question is, as the era of greater selectivity unfolds, will there be enough for everyone?
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Global credit funds & CLO's
February 2023 | Issue 252
Published in London & New York.
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