It’s critical to understand that lower marks are not necessarily indicative of declining borrower performance

Randy Schwimmer

Co-head of senior lending Churchill Asset Management

Despite rate hike plans going unchecked, there is cause for optimism in private credit

As unhappy as bank failures make central bankers, there must have been gratitude among Fed members for the current round. They seem to have delivered a sobering message to markets on the perils of financial risk and tightened credit without widespread systemic damage.

Various indicators — the treasury curve, treasury spreads and stock prices — wobbled with the failures of Silicon Valley, Signature and Silvergate banks. Analysts estimate these events were the equivalent of at least a 25 basis point Fed hike. And even as the Fed in its March meeting piled on by raising its benchmark another 25bp, the economy continued to shrug it off. Initial jobless claims of 198,000 remained below the pre-pandemic average, signalling that employers largely kept holding on to their workforces.

In private markets, there are few signs of growth weakening. A recent report from Lincoln International, a noted middle market US investment bank, contained data derived from valuations on hundreds of portfolio companies of direct lenders. Over 80% of those businesses demonstrated higher sales last year than 2021; about two-thirds reported improved cashflows.

While some interpreted this as evidence that borrowers are challenged by mounting expenses, including interest and wage pressures, 2021 ebitda was up for fewer companies versus 2020. This means the 2022 corporate vintage fared pretty well despite whatever drags the overall economy delivered.

While full year 2022 numbers aren’t complete, our own Gryphon Index, a similar measure of portfolio performance, reported the same asymmetric outcomes. Borrowers sported a 40% increase in revenues and a 30% improvement in ebitda. This includes add-ons as well as organic growth, but the benefits of larger platforms typically accrue to portfolio quality.

Borrowers are in a good spot

We suggest cause for optimism. Certainly, the full impact of escalating rates has not been felt. But in defensive sectors, where experienced private managers play, companies are aided by a variety of tailwinds. Those with low capex and labour costs have room to manoeuvre when other expenses rise. Their market leadership and value-add products and services allow for pricing power — helpful in the current environment.

Meanwhile, deal-making trends continued on the path set before the banking crisis, with the proviso that anything with a financial service or tech bent receives extra scrutiny.

Improving existing terms is difficult

Headwinds to repricings, amendments and extensions revolve mainly around lack of clarity on price-clearing levels. Investor pushback is centered around where the secondary loan market is trading. In current market conditions, it’s a challenge to improve existing terms.

Absent an active secondary market, private loan valuations are measured against broadly syndicated loan marks — but volatility in public credit trades has led at times to higher yields there. Since investors in illiquid credit demand a premium to broadly syndicated loans, anything eating into that differential could make privates look cheaper.

But this disregards the disparate vitality of the two markets. Large cap loan issuance has been quiet for months, while direct lenders now lead leveraged buyout financings by a 15:1 margin. Private investors are benefiting from healthy deal flow even as private valuations have eased 2.5% since the end of 2021.

While historic prices look lower, it’s critical to understand that lower marks are not necessarily indicative of declining borrower performance. If current portfolio metrics are any measure, a recession does not appear likely anytime soon.

It’s also instructive to remember that companies don’t need to grow to be good credit risks. Indeed, ultra-high growth businesses often prove to be more volatile through economic cycles.

Slow growth — or moderately soft operating results — don’t necessarily lead to loan defaults or losses. As one friend is fond of saying: in private credit your horse doesn’t have to win the race, just finish it.

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Global credit funds & CLO's

April 2023 | Issue 253

Published in London & New York.