North American Private Credit: Assessing the Landscape
The North American private credit market seems to be adjusting well to inflation and rising interest rates, but changes are likely coming, especially if a recession emerges and/or if rates remain elevated for longer than expected.
A Time of Transition
Compared with the last time a recession loomed, the North American private credit market today certainly looks to be in a stronger position. Loan-to-value ratios are now in the 40–50% range compared to ratios in the 60–70% range in the wake of the global financial crisis in 2007 and 2008, providing much more of an enterprise value cushion and incentive for PE firms to support portfolio companies.1 Going into a potential dislocation, interest rate coverage is much stronger now at around 3x, versus 2x in 2007, although coverage has deteriorated with the rate hikes.2 The asset class also benefits from having greater liquidity today than it did before the crisis, when balance-sheet capital at financial companies and insurers was constrained. Until now as well, many companies have been able to raise prices to reflect higher costs without affecting customer demand. Companies also are working on ways to reduce expenses and improve margins.
However, while there are many signs of stability, it is also important to recognize that a lag exists between the time base rates start to rise and the time their effects start to be felt. When second- and third-quarter financial results arrive, it is likely that the impact of rising rates and higher inflation will become more evident. That is when the value of well-constructed portfolios of good companies and the experience of lenders and managers will become apparent. We believe that a conventional recession will reveal the true strengths and weaknesses of managers, and wider and more fundamental disparities in manager performance will be more pronounced.
1. Source: PitchBook. U.S. PE Middle Market Report Q4 2022. As of December 31, 2022
2. Source: PitchBook. U.S. PE Middle Market Report Q4 2022. As of December 31, 2022.