Two tests for private credit

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Private credit and the credit cycle

On Friday we looked for private credit’s special sauce, the little something extra that explains the asset class’s remarkable recent growth. (“Private credit” encompasses many things, but here we largely mean direct lending to corporations.)

The short answer: an underserved class of borrowers, tightly written contracts, the absence of mark to market, and the flexibility of bilateral lending relationships. But this formula for superior risk-adjusted returns is untested in a serious credit cycle. And assuming rates stay high for a while, a serious credit cycle looks hard to avoid.

Private credit may soon face two tests.

High rates stressing borrowers

Already, the default rate on leveraged loans, private credit’s nearest competitor, is rising fast (from 1.4 per cent a year ago to 4 per cent now) and ratings downgrades are accelerating. Both are floating-rate asset classes but, for the reasons mentioned above, trouble will probably come more gradually to private credit. 

However, once the credit cycle bites, lenders’ incentives will change. As one industry watcher told us, while lenders have so far been rewarded for shovelling cash out the door, how they manage loan workouts (ie, renegotiations to avoid default) will eventually become a “key point of differentiation”.

Some private credit investors point to one reason for calm: bigger equity cheques in leveraged buyout deals, which are a big line of business for private credit. In an LBO, some chunk of the money raised comes from a private equity sponsor and the rest comes from lenders. Since creditors are at the top of the capital stack, more PE sponsor equity means less risk for lenders. In the past year or two, the share pitched in by equity investors has noticeably risen. This provides “both more of a cushion for creditors and an even larger incentive for sponsors to support businesses if necessary,” says Laura Holson of New Mountain Capital.

But losses at the borrower level will have to be absorbed by someone, and private equity won’t be thrilled to be on the hook. As equity shares rise, sponsors have an incentive to pursue contractual terms that let them cash out as soon as possible, for example by raising new debt to pay dividends. In that sense, stronger debt-to-equity ratios can sometimes be “illusory”, Moody’s analysts wrote in a note in May.

Private credit investors counter that their contracts are tip-top, which we’ve no reason to disbelieve. What’s clear is that an “uncertain balance of power” exists between private equity and private credit in LBOs, says Mike Patterson, head of direct lending at HPS. He explains:

LBO lenders rely on PE for opportunities, and PE needs a lender for the next deal. You need their deal flow, they need you to stick around. You can discern good deals from this flow, but you need to preserve the ability to be selective.

And in particular, if an investment doesn’t go according to plan, can you stand up for your rights as a lender or are you so dependent on a particular LBO sponsor’s deal flow that you are forced to make concessions you otherwise wouldn’t?

Private credit becoming saturated

The sector has grown remarkably fast, but it won’t forever. 

In the near term, the sharp drop in private equity fundraising is constraining private credit’s growth. And in the longer term, LBO financing in particular looks like an increasingly crowded field. “LBO lending is the most efficient way for private credit firms to get in, because the logistics are taken care of for you,” says Patterson. However, he adds that “spreads will compress cyclically from their 2022 highs, and over time lenders will have to be clearer with their investors about what they’re getting from scaled-up private credit”.

Not everyone agrees. “The private credit pie is growing fast enough that there’s room for everyone,” says Holson. Part of this lies in taking lending business from the syndicated bank loan market. Barclays estimates the cannibalisation at $150bn over several years, something like 10 per cent of the cash allocated to private credit. As rates have risen, banks and the biggest bank loan buyers (called collateralised loan obligations, or CLOs) have pulled back from the market, wary of defaults and downgrades.

Armen Panossian, who will take over as Oaktree’s co-CEO next year, makes the point that loan market retrenchment looks like it is supporting private credit:

Banks have meaningfully withdrawn from originating in the broadly syndicated loan market. The little activity you do see is mostly refinancing.

CLO formation is now meaningfully weaker than 2019 or 2021, and because of that, more people are looking at private credit to finance transactions.

For private credit firms, one alternative is to look outside LBO financing to less crowded areas. Panossian likes investing in middle-market life sciences companies, which requires scientific expertise but is less cyclical and more differentiated. Patterson’s firm favours logistically complex deals that earn higher spreads, such as HPS’s 2020 loan to Bombardier.

We’ll have more to say on private credit in the coming weeks, as we try to better understand this fast-changing, diverse sector. If you have ideas for what we should write about, do send an email.

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