Now that the proverbial rubber has met the road, many investors are questioning what’s in store for private credit in the months (and years) ahead. In many ways, the current volatility is setting the stage for significant opportunities—but managing the downside is critical.
COVID-19 and the fallout from the prolonged global shutdown have certainly brought challenges to private credit. Relative to past events like the global financial crisis, the effects on many companies have been swift and severe—companies that performed well in January and February saw revenues decline to almost zero in the following months as demand dropped off. There is no way to know when this event and the related economic slowdown will ease, though it is looking increasingly likely that many companies face a long, slow road to full recovery, particularly those in industries more affected by shelter-in-place orders.
There are bright spots, to be sure. As an asset class, private credit can offer an opportunity to invest in high-quality companies through private investments that offer a potential yield premium relative to the broadly syndicated loan markets—with greater downside protection in the form of covenants. But some strategies and segments of the market are better positioned to deliver attractive risk-adjusted returns than others, and the key going forward will be to differentiate those capable of effectively managing the downside.
For the last several years, we have continued to see the most attractive value in what we consider the traditional or true middle market—companies with EBITDA between $15 and $50 million. Within this space, we see particular value in the more conservative parts of the capital structure, namely first lien senior debt, with a specific focus on industries that are truly suitable for illiquid investments, avoiding spaces such as retail, restaurants and oil & gas.
Realizing the Consequences of Late-cycle Style Drift
Today, traditional middle market companies have a potential advantage over their smaller and larger counterparts. On the one hand, they have greater enterprise value than the lower part of the middle market , where loss potential in the event of default tends to be higher as smaller companies typically have fewer “levers to pull” in the event of financial difficulties. On the other hand, relative to the upper end of the market , mid-middle market companies are likely to require less financing to bridge themselves through shorter-term shocks and periods of deteriorating economic growth.
This sweet spot has also been more insulated in recent years from some of the riskier behavior exhibited in other parts of the middle market.