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Opinion Direct lending
Private credit issuers stand or fall on the performance of the business
by Randy Schwimmer
Randy Schwimmer
Vice chairman
Churchill Asset Management
Unlike the fast and furious movers in public equities, private credit delivers steady income streams
Earlier this summer, we attended the 40th annual conference of the Florida Public Pension Trustees Association in Orlando. Attendees included municipal pension board members, plan sponsors and administrators. In our keynote presentation we highlighted macroeconomic factors investors face.
While researching for our talk, we came across this interesting factoid: “42% of the companies in the Russell 2000 index are unprofitable”. Now it’s fair to ask whether some of these companies are investing for growth, hence cashflow negative, or if expenses are simply outpacing revenues. And it would be helpful to compare today’s measure with the last five years to see if higher rates could be the culprit.
But to some extent, businesses being under financial pressures should not be a surprise. The cost of debt capital has soared over the past two years. The cost of energy and housing and some raw materials continues to be higher than historical averages. Growth is slowing in the US, with some economists scaling back from previous GDP estimates of 2.4% to 1.5%.
Yet public equity markets have demonstrated marked exuberance this year in the face of those headwinds. Until recently, with cooling labour conditions signalling the slowdown is at hand, indices were setting record highs almost weekly. Of course, sector focus plays a role, with almost 20% of the Dow being tech stocks, and an even greater share for the S&P 500 (30%).
Equity price spikes can lead to pull-backs
The Magnificent Seven, representing 40% of the Nasdaq 100, is an extreme example of industry concentration. The market cap of Nvidia was USD 3tn at one point — it was vying with Apple and Microsoft as the world’s most valuable company. So much for diversification. Are valuations in AI and tech overblown? Rapid price climbs can lead to pull-backs, as we saw when NVDA (Nasdaq) lost USD 430bn of value in three days. Such is life in the fast and furious tech lane.
In the credit lane, growth is slowing for middle market companies. Even in business services and other defensive arenas supported by private equity sponsors, we’ve seen revenue increases in the mid-single digits, not the low double-digits prior to the Fed’s rate hikes. Sophisticated credit investors understand slow growth is their friend. Hence the attraction to alternatives in the traditional 60/40 allocation model. Investors need valuation and price stability through a variety of economic and market cycles.
Private credit, in turn, has become core to an alternatives allocation. When rates rise, it’s a natural hedge to fixed income exposure. When rates fall, it retains a consistent premium to public credit. Amid rate volatility, it produces a steady income stream with minimal disruption from headline risks.
Unlike the fast and furious movers in public equities, private credit issuers are non-traded entities. Their valuations stand or fall based on the performance of the businesses. And because direct lenders buy and hold their loans, the asset class is heavily managed.
Prioritising stability over growth
With little way out short of refinancings or company sales, portfolio construction is everything in private credit. How loans perform reflects directly into investor returns. This puts the onus on portfolio managers to select not just the highest quality issuers, but the most stable industries. Revenue growth is a nice-to-have, not essential, component in private credit investing. Slow growth, even occasional slow negative growth, is manageable. Fast growth is not necessarily a plus, providing a helpful contrast to the tech-heavy stock markets. A good equity story is not necessarily a good credit story, and vice versa.
Private credit managers focus on industry as well as borrower concentration. This is true in sub-sectors of larger industry classifications, such as healthcare and business services. They tend to be generalists with certain areas of expertise. This is different from large CLO platforms, which have teams of analysts covering aerospace, transportation and gaming, etc.
Finally, risk/reward in private credit is not asymmetric. Limited upside is accepted along with limited downside. There are no big winners, since you only expect to back get your principal and interest. It’s a horse race where, as one friend puts it, all you have to do is finish.
