Private Credit: Back to School with Optimism in the Air
As investors say goodbye to the beach and return to their desks, the private credit market greeting them upon their return offers some of the most attractive dynamics in years.
Heading into the tail-end of 2023, private credit is benefiting from higher base rates, attractive spreads, and a thawing origination landscape.
Earlier this year, the slowdown in high yield and broadly syndicated loan markets combined with volatility in the banking sector to create a shortage of capital in the traditional middle market—an ironic statement given the ever-increasing popularity of the asset class among investors. The result was that with less capital competing for deals, borrowers faced a higher cost of capital as well as improved credit documentation.
For investors, this turned out to be a good thing—in the form of higher yields and better structural protections. And it’s also had the positive knock-on impact of preventing borrowers from taking on the excessive levels of leverage that we saw when rates were low, leading to lower levered, more resilient capital structures.
Now, heading into late-2023, with base rates at ~5%, we are currently seeing all-in yields in the 10–12% range for senior “down the middle” deals with lower leverage and first-lien risk.1 From a historical basis, the risk-return on offer looks extremely attractive today. These tailwinds appear to be setting up for an attractive direct lending vintage in 2023 and 2024. And we are not surprised to see increasingly strong demand for investors to put capital to work in this space.
There are, however, some headwinds.
Will Managers Be Able to Put Capital to Work?
One of these comes down to deployment—the lifeblood of private debt. With the M&A market slower, thanks to economic and pricing uncertainty, there are fewer new deals available to private lenders.
However, for lenders with large and established portfolios, there are opportunities to generate deal flow from current portfolio companies as their private equity owners continue to execute on buy and build strategies. For example, at Barings, our existing portfolio is generating significant deal flow for us this year—in North America, approximately 70% of our deal activity has come from the existing portfolio. This is particularly notable not just in terms of the visibility of deal flow and the ability to reliably deploy capital, but also because it does not require any sacrifices in quality to do so. These are typically accretive add-on acquisitions for companies that we have underwritten and invested in for years
This has served us well in the slower M&A environment of 2023 to-date, but broader market dynamics may be about to get more supportive. In fact, we are seeing indications from private equity sponsors, banks, and others that markets are beginning to thaw and that the origination pipeline to support private equity firms in traditional LBO structures will look much more robust in the latter part of 2023 and into next year. In other words, we think it’s about to get easier to deploy capital.
The Default Picture
Another headwind comes in the form of the elevated risks of default. The higher returns that private debt enjoys, means higher interest costs for the borrowers and therefore greater pressure on margins and profitability. These come after a year or two of elevated inflation and the supply chain challenges that followed Covid.
We are therefore likely to see an increase in defaults as a result, but these are likely to impact more highly levered businesses and more cyclical industries. Those who have built more aggressive portfolios in the recent post-Covid ‘good times’ may come to regret some of the excessive risks taken. As a result, we do expect to see a bifurcation in terms of manager performance with those more disciplined and conservative managers outperforming.
This bifurcation could be a positive evolution for the asset class as it will reaffirm the importance of discipline and caution in delivering the stable and defensive income that this asset class has become renowned for. It will also reaffirm the role that direct lending can play in a portfolio, that of a resilient asset class, generating an attractive floating rate illiquidity premium.
All-in-all, it remains to be seen what the macro backdrop has in store, but given the yields currently on offer, along with improved structures, less leverage and a thawing origination backdrop, a variety of factors are converging that suggest that 2023 and 2024 private credit vintages could be some of the most attractive we have seen in years. Add on to that the fact that we believe institutional investors are still structurally underweight the asset class, and we believe that private credit should have strong structural support for years to come.
It’s never fun to leave the beach and come back to reality. But all things considered, it’s hard to imagine a more attractive environment to return to than the one we see in private credit today.
1. Source: Barings’ observations. As of August 9, 2023.
