Amid Rising ‘Mequity’ Risk, Boring Can Be Beautiful
Market participants have been trying to call the end of this credit cycle for years. And while the end still might not be imminent, late-cycle behavior has become apparent in parts of the private credit market. Specifically, as more managers have raised larger and larger funds, there is more capital chasing deals in the space—especially for the very largest transactions in the upper middle market. Additionally, as the popularity of unitranche—essentially a hybrid between senior and mezzanine debt—has increased and leverage has continued to rise, some market dynamics have become distorted. Most notably, the spread paid to investors for taking increased risk has tightened relative to historical levels.
As a result of this, we have witnessed some instances in which deep first-lien debt has a much higher risk profile than is typical of traditional senior debt. In fact, in many cases, these highly leveraged first-lien deals—often marketed as senior debt—represent something more akin to “mequity” risk—or mezzanine/equity risk—given the deep leverage and often high level of execution risk in converting adjustments to cash.
Ultimately, we do not believe that credit spreads in many of these transactions are providing adequate compensation for the junior capital type of risks that are inherent in these structures.
There is an interesting dynamic playing out in private credit today, both in the U.S. and in Europe. Essentially, there is significant pressure both at the top and bottom ends of the middle market. As a result, and as we discussed in detail in a recent podcast, we see the most attractive value today in the more traditional, true middle market—in essence, boring is beautiful. Within this space, we see particular value in traditional first lien senior structures that are backed by junior capital, where the potential return relative to the amount of leverage looks more attractive, in our view, relative to more highly leveraged deals.
In Europe, we see a potentially attractive opportunity in first lien debt with no junior capital behind it. This type of debt, on average, tends to exhibit lower leverage relative to the U.S. market, with attractive yield per turn of leverage—a critical component of evaluating true risk-adjusted return.
“… highly leveraged first-lien deals, often marketed as senior debt, represent something more akin to “mequity” risk—or mezzanine/equity risk—given the deep leverage and often high level of execution risk in converting adjustments to cash.”
The strong fundraising environment in recent years has encouraged managers to move up in the market and raise bigger funds. Because these managers still need to deploy capital over a specific period of time, typically two or three years, it can be more efficient to ramp these vehicles with larger investments in upper middle market companies than to try and find enough smaller, more traditional middle market investment opportunities. You could argue that makes some sense in terms of efficiency, but in our view, it has introduced significant style drift.
In fact, the willingness to invest in these larger deals has actually blurred the lines with the broadly syndicated loan market—resulting in private market transactions with loose covenants and weaker structural protections. While this isn’t necessarily a bad thing in the more liquid broadly syndicated market, it is more troubling in the private lending space, where the ability to sell out of a deal is, at best, very limited. In the context of today’s late-cycle environment, one bold prediction going into 2020 is that this type of strategy—even if it looks somewhat attractive in the short-term—will not prove beneficial longer-term, particularly if the economy takes a turn for the worse and we start to see an increase in defaults.
This commentary is provided for informational purposes only and should not be construed as investment advice. The opinions or forecasts contained herein reflect the subjective judgments and assumptions of the investment professional and do not necessarily reflect the views of Barings, LLC, or any portfolio manager. Investment recommendations may be inconsistent with these opinions. There can be no assurance that developments will transpire as forecasted and actual results will be different. We believe the information, including that obtained from outside sources, to be correct, but we cannot guarantee its accuracy. The information is subject to change at any time without notice.