@Churchill AM
Randy Schwimmer: The US Federal Reserve’s attempts at curbing inflation through a combination of rate hikes and quantitative tightening have had myriad of effects on the market, not to mention apprehension about an economic downturn.
Markets have been going through various stages of anxiety since November 2021, when the Fed threw in the “transitory” towel. Increased volatility has been one of the results. Another has been a scarcity of capital thanks to, in part, the Fed’s reduction of its balance sheet from $10 trillion to $7 trillion over time.
"High-yield bond prices have cratered in the face of rising rates, and the
broadly syndicated loan market has seen the SOFR benchmark go from 0 to 4%."
It has also announced its intention to shrink US bank reserves from $3 trillion to $2 trillion. Draining the “pool” has tightened liquidity on trading desks as well as restricting banks’ wholesale financing operations. This stands in stark contrast to the world of plenty that has existed in capital formation since the post-GFC recovery.
At the same time, higher rates and recession worries have roiled public credit markets. High-yield bond prices have cratered in the face of rising rates, and the broadly syndicated loan market has seen the SOFR (Secured Overnight Financing Rate) benchmark go from zero to 4% in a year’s time. The resulting higher all-in spreads of floating rate loans puts a magnifying glass on existing financings done in a near-zero rate environment.
Add to this mix a potential recession next year – an increasingly likely possibility – and investors understandably predict higher default rates. There’s little outward sign of this yet, but with an increased share of wallet going to paying interest payments, issuers’ Q3 and Q4 operating performance will be closely watched.
"Being unrated and clubbed among small lending groups, these middle
market loans don't trade and are thus less subject to volatility."
Meanwhile, retail cash is departing both bond and loan mutual funds on a massive scale. More than $50 billion of combined outflows have been recorded year-to-date; this along with close to 10% current yields being demanded for new deals has put a big dent in primary deal flow.
Private credit, governed not by fund flows and CLO formation, but locked-in, long-term capital from investors in illiquid assets, has benefited from public credit dislocation. Being unrated and clubbed among small lending groups, these middle market loans don't trade and are thus less subject to volatility.
That aspect of private credit, along with less correlation to liquid assets and higher relative yields, is integral to the asset class. Now as the spotlight has moved to heightened systemic credit risk, investors are waiting to see how other benefits, including full collateral and tighter structures with covenants (unlike the BSL, cov-lite dominated market) will fare.
Randy: No question that interest coverage has tightened for all leveraged loan issuers. But experienced loan managers are attuned to the risk of higher rates. Since our firm’s inception back in 2006, we’ve modelled in the forward rate curve to test future cash flows for any potential transaction. Those have always included a hypothetical recession within 24 months of booking the loan.
"Coming out of COVID was a natural reflation of prices coming from a
very low point in what was a very short recession in the spring of 2020."
We typically look for companies with high free cash flow characteristics and low CAPEX in defensive industries. These are generally business-to-business, less consumer-facing borrowers where any cyclical impact is muted. We build in a cushion in all our deals so that if interest rates go up and/or cash flows contract, they can still comfortably service the debt.
The advantage of financial maintenance covenants – leverage tests, for example – is that they are triggered by higher leverage whether caused by higher debt or weaker cash flows.
Inflation is a different matter. What we saw coming out of COVID was a natural reflation of prices coming from a very low point in what was a very short recession in the spring of 2020. As we now are all painfully aware, for various complicated reasons, inflation has become more systemic.
Middle market companies are wrestling with higher input costs like everyone else, coming from a variety of sources. Besides supply chain challenges, there has also been a greater demand for goods and services. Each company and its private equity owner have different ways of ensuring that they can pass costs along to the customer, either with escalation clauses in their contracts or through alternative product sourcing.
Randy: Most of the elements of the current economy and capital markets paint a constructive picture for investors. Terms and structures are tightening, spreads over SOFR are up 50 to 100 basis points and leverage is down about a turn of EBITDA from a year ago. The all-in-yield for conservatively structured senior secured loans is approaching 10%. We are also seeing more subordinated debt opportunities.
"The healthy deal flow from our close private equity relationships are
driving a more careful allocation of our dry powder."
Of course, what represents tailwinds to investors are headwinds to issuers; borrowers of all stripes are facing higher cost financings and execution uncertainty.
As a leading private debt manager with decades of management experience, we have the playbook for deal making in this environment. The healthy deal flow from our close private equity relationships, as well as opportunities from the public sector, are driving a more careful allocation of our dry powder. With all the uncertainty we’ve been discussing, it makes sense to be selective and cautious. But we’re confident that the well-rewarded strategies we’ve successfully employed through a number of cycles will sustain us through 2022 and into 2023, regardless of what the economy throws at us.
Randy: Private debt’s proof of concept will be tested again with this next cycle. The regime of higher interest rates and inflation are putting pressure on balance sheets and structures. But the most experienced managers with large pools of diversified capital and decades of private equity relationships can now deliver better yields and better structures to investors.
"We differentiate by sourcing deals regardless of the investment climate.
This comes down to the strength of a manager’s private equity relationships."
And they can do so while avoiding the challenged sectors that have suffered higher defaults over time. We saw that in 2020 when exposure to retail, travel and leisure, cruise lines, and apparel all were negatively impacted during that brief downturn. This next period will likely be more long-lasting in its recessionary impact. My sense is that we will look back years from now and see the virtues of private debt made this time it’s coming of age.
Randy: We differentiate by sourcing consistent quality deals regardless of the investment climate. This comes down to the strength and stickiness of a manager’s private equity relationships.
The next smaller circle of differentiation can be found from scaled managers offering comprehensive financing solutions across the capital structure taking market share. This in turn allows these managers to provide their investors with a wide range of investment products to meet their varying requirements and risk/return preferences. Ultimately, this advantage compounds as investors reward top managers with incremental capacity.
