The right climate doesn’t guarantee a great bottle of wine

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Global credit funds & CLO's

January 2021

| Issue 230

Published in London & New York.

January 2021 | Issue 230

Opinion Direct lending

The right climate doesn’t guarantee a great bottle of wine. The skill of the winemaker is also vital

Randy Schwimmer

Head of capital markets and origination Churchill Asset Management

This year could still turn out to be the best private credit vintage ever

Hard to remember now, but back on 23 March the Dow bottomed out at 18,591, a move mirrored in other markets globally as coronavirus fears took hold. Today it stands at 30,000, largely on vaccine hopes and political stability.

Other elements are little altered. Interest rates remain at record lows, joblessness could be poised for an up-spike, and a third wave of virus infections in the US is well underway. Nevertheless, liquid markets take comfort from Fed support and a divided Congress that conditions won’t stray far from constructive.

Also unchanged are supply/demand dynamics in illiquid markets. Dry powder is plentiful because yield appetite persists among investors. Assets for sale fill pipelines because owners need realisations. Private equity buyers must put money to work, and private credit providers will finance those transactions.

This leads some observers to fret about frothy market conditions. “Aren’t you worried lenders will get too aggressive?” one reporter asked recently. “Or that too much capital is being raised for private credit?”

Refinitiv LPC’s Q3 2020 middle market sponsored private deal data showed sponsor volume of $18.3 billion, back from the dismal Q2 numbers of $10 billion. But that pales in comparison to the $36 billion in Q3 2019. Midcap buyouts were even more anaemic. Only $3.3 billion of third-quarter LBO activity was recorded — the same as in the second quarter.

Purchase price multiples have dropped

There’s little froth evident in valuations. Purchase price multiples were down across the middle market in the crisis. For the first time since 2017, prices for issuers with ebitda below $20 million fell below 10-times ebitda. Even these metrics are misleading. Valuations blend “haves” — covid-friendly businesses going for higher multiples — and “have-nots”, whose prices have been flattened.

With slowing deal flow, don’t technicals favour issuers? Memories of March’s market collapse are fresh in risk managers’ minds. Holds are below pre-covid levels, keeping direct lending liquidity modestly in check. Sponsors are also tightening their trusted circles, resulting in fewer, more capable providers.

Private credit features a spectrum of participants. Some have long track records of investing successfully in the industry. Others, as one friend put it, “operate without a driver’s license”.

Another friend, the head of a private credit consultant, compared the asset class to ice cream. “I sent my son to the store for some vanilla. He calls and asks: ‘Dad, do you want French vanilla, vanilla bean, old-fashioned vanilla, classic vanilla, lactose-free vanilla or natural vanilla?”

Isn’t a double-dip recession coming?

The reporter wondered about our contention that 2020 could be the best vintage for private credit in a decade. “Won’t higher infection rates hurt many consumer businesses?” he asked. “Then aren’t we at risk of a double-dip recession?” Economists expect slower but still positive growth for Q1 2021. Experienced investors are uncovering companies unhurt, even helped, by the crisis. Direct lenders are eager to finance them.

“It’s like a vineyard,” we offered. “Sunshine, temperature and rainfall combine to produce a great vintage. But the right climate doesn’t guarantee a great bottle of wine. The winemaker’s skill, equipment, soil preparation, etc are also fundamental.”

So what’s in the formula for a great loan vintage? A recovering economy that discourages excess risk taking. Interest rates low enough to benefit corporate cash flows. Public credit volatility that reinforces a cautious approach and encourages borrowers to seek private financing options.

But individual manager competence is key: knowing which sectors to avoid, especially when consumer-facing businesses are in turmoil. And understanding the importance of tight covenants and sound structures. But the real secret sauce is credit selection. The skill of picking the right deals is earned from decades of experience.

As the great winemaker Robert Mondavi once said: “You can make bad wine with great grapes but you can’t make great wine with bad grapes.”

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