Should Investors Press Pause on Private Credit Commitments?

Private debt, along with infrastructure, topped the table of asset classes to which investors are planning to increase exposure in a recent Global Asset Owner Survey. Floating rate structures and other appealing characteristics continue to draw both existing and new investors, with the attractions reinforced by expectations of a strong upcoming vintage.

In recent months, however, we have seen some investor clients showing hesitation with deployment and, in certain cases, pulling back from planned commitments. This hesitation can have more damaging consequences for private credit portfolios than would be the case for illiquid equity-type strategies such as infrastructure (equity) and private equity. The shorter investment time horizons in private credit and ongoing self-liquidation as positions mature mean that portfolios will shrink relatively quickly unless capital is recycled back into the asset class on a regular basis. Moreover, as in other illiquid asset classes, it can take months to commit capital (given the importance of selecting the right manager in this climate) and some time for commitments to then be called. Maintaining private credit portfolios requires both discipline and forward planning.

Three reasons are typically at the forefront when delaying or reducing commitments

Three reasons are typically at the forefront when delaying or reducing commitments. First is a ‘push’ factor: the denominator effect. Market falls have left investors with theoretical ‘overweight’ positions in illiquid strategies where declines are lagged, smoothed and possibly even understated. The absence of market price discovery can be helpful for asset owners, in that it discourages short-termist pro-cyclical behaviour and helps to support overall portfolio valuations, but investors must be cautious about using apples-to-oranges valuation comparisons as a basis for ongoing deployment decisions.

Second is a ‘pull’ factor: the rise in fixed income yields. Thanks to higher interest rates, investors that were simply seeking a minimum acceptable return in absolute terms may now be able to obtain that figure (with their desired risk profile) in conventional bonds. Although inflation remains high in many ‘developed’ economies and further rises in interest rates would be detrimental to the value of fixed-rate bonds, fixed income is undoubtedly more attractive in terms of return today than it has been for many years.

The third—and related—driving force is a perceived narrowing of the illiquidity premium in this asset class. It can be somewhat challenging to measure this differential accurately. In addition, an investor committing today will not know the interest rates at which their capital will be deployed. Unlike fixed income, where commitments entail buying a slice of the current crop of bonds, private credit commitments give the selected asset managers the ability to deploy capital into newly negotiated deals over the next one or two years. If conditions are as challenging as many expect (or indeed fear), private credit spreads are likely to be increasingly attractive to investors. Moreover, their value should be insulated from future rate hikes by floating rate structures.

Key shifts in private credit

All three of the concerns above are worth exploring with care and debating with investment teams, trustees and fund consultants. Investors weighing the pros and cons of delaying or reducing commitments may find it helpful to consider the current (broadly pro-investor) dynamics within private credit.

On the risk side, loan multiples (the amount lent as a multiple of an entity’s earnings) have generally reduced, as have ‘Loan-to-Value’ ratios, resulting in less risky credit profiles. Covenants are evidently becoming stronger and increasing in number, such that both interest cover and loan multiple metrics are often now incorporated and tolerance for adjustments to earnings (add-backs) is significantly reduced. Finally, amid challenging economic conditions, it is worth remembering certain advantages for private lenders versus fixed income investors, such as the ability to be very selective and negotiate structures with a strong hand: these can mitigate pricing and execution risk.

As for returns, our recent research and conversations indicate that credit spreads for private credit deals have widened by 100-150bps. Meanwhile, JP Morgan research indicates that BB syndicated loan spreads have widened by 150bps while BB HY bond spreads have widened by 120bps. This widening indicates that the ‘illiquidity premium’ is essentially being maintained, although it feels smaller as a percentage of total return than was the case twelve months ago. Up-front fees/OID for private loans are also up to 1% wider now, boosting the overall return to investors. Perhaps most importantly, we are now seeing considerable anecdotal evidence of a decline in traditional bank lending, which should strengthen the premium available to alternative lenders.

We are now seeing considerable anecdotal evidence of a decline in traditional bank lending, which should strengthen the premium available to alternative lenders

The retrenchment in bank lending is also being affected by declining valuations on the private equity side. Those mark-downs are now kicking in in earnest, particularly in Real Assets (real estate and infrastructure) equity. In hypothetical terms, a building that was worth £100 million and being financed at 60% LTV when capitalisation rates were 4% may now be worth £75 million on paper with capitalisation rates at 6% and will therefore require refinancing at 80%+ LTV. A bank that provided the initial financing may well not be in the market for higher-LTV business in current economic conditions. While equity might plug part of the gap, the solution is more likely to lie in private debt (such as a stretch-senior loan or a slice of mezzanine). Other alternative lending strategies, such as trade finance and receivables, are likely to benefit from the decline in traditional (bank) lending as well.

Will portfolios show resilience?

The discussion above relates, of course, to new commitments. Yet what of existing positions? How will investors’ current portfolios fare in this climate?

Our recent analysis supports the expectation that many (if not all) private credit managers’ current portfolios will prove resilient through challenging conditions. The vast majority of transactions are not only secured on the shares of the borrower (or in the case of real estate debt, on the property or properties) but also have maintenance covenants that give lenders the ability to anticipate and resolve issues before a default occurs. Indeed, lenders’ experience through the Covid-19 crisis was that equity owners were willing and able to come to the table with a sole lender or small club of lenders in order to avoid triggering covenant breaches that could lead to enforcement.

Interest cover, however, remains a cause for concern: higher interest rates do theoretically make it more difficult for borrowers to service their debt. Although headroom has been reduced, the real impact (in the sense of prospective or actual defaults) so far appears to be minor. This should not, perhaps, surprise us. If, for example, we imagine a loan at 5x EBITDA made last year, the all-in cost of that debt might have been 7%, implying a EBIDTA:interest cost ratio of nearly 3:1. If the cost of that debt has migrated to around 10%, the ratio remains 2:1. In other words, earnings would have to halve before a business was no longer generating enough cash to service the interest cost on their debt. In short, while there may be some casualties (as is the case across all markets, public and private), debt servicing should largely remain manageable. Refinancing will likely be more challenging; this should benefit investors who are allocating now for deployment over the coming months, as discussed above.

Handle caution with care

In times of considerable uncertainty and volatility, it is not surprising to see some hesitation and confusion around illiquid strategy commitments. Yet investors must approach these debates with care. This is particularly true within the private credit asset class, given the continual activity that is required to maintain an appropriately sized and well diversified portfolio. Leaning in ‘when others are fearful’ is easy to advocate but, all too often, proves hard to achieve in practice. Yet failing to commit today may lead to an imbalanced portfolio and leave excess returns on the table.