Private Debt’s thunder road
18 December 2023
A storm has been looming on the horizon for the last few years, one characterised by macroeconomic uncertainty, relatively high inflation, rapid interest rate rises, and an operating environment that shifts rapidly. No part of finance is immune to the effects we currently see, but more so than any other sector the mood in private debt seems positive. Continuing then along the lines of the last decade and a half, is Private Debt riding the thunder road to the promised land?
Following the global financial crisis private debt saw spectacular growth and during the good times it offers investors a myriad of benefits, including potential pricing premiums, positive credit protection structural characteristics, asset to liability matching aspects that are favourable, diversification, and steady cashflows. Challenging times, it seems, could offer investors additional benefits including economic resilience due to loan structures and covenants, potential for opportunistic and wider investments as issuers pay a premium to access financing, and more attractive spreads.
The asset class currently offers investors risk adjusted returns without forgoing a robust downside protection.
This is clearly illustrated by the Covid-19 pandemic, during which private debt issuance rose to record highs given the asset class displayed strong levels of credit protection, relatively good value, and attractive spreads when accessing international and public issuers.
Given the current backdrop, borrowers are searching for tailormade solutions that provide them with a certain amount of flexibility beyond what can be achieved on the public market and private debt is bringing its weight to bare. “Alternative lenders are adapting to provide solutions across the capital stack,” notes Caio Baruffaldi, Head of Private Debt at Allianz Investments Luxembourg. “This means the asset class currently offers investors risk adjusted returns without forgoing a robust downside protection. Additionally, these loans can be less volatile in comparison to traded securities, and present higher recovery rates given the bespoke nature of the covenants,” Baruffaldi continues.
The increasing popularity of this asset class is denoted by the bespoke nature of the loan instruments and the options available. “We’ve seen several private debt loans with floating rates attached,” highlights Francesca Raffa, Luxembourg Head of Private Debt at Aztec Group, boosting the popularity of these instruments during times of turmoil given that “if interest rates increase on a macro-level, it actually improves profits for investors. In addition, the steady cashflows derived from the loan instruments result in a steady distribution-flow back to the investor.”
The steady cashflows derived from the loan instruments result in a steady distribution-flow back to the investor.
Nonetheless, the environment in which firms currently operate is not without its challenges and investment approaches are undoubtedly changing. Existing portfolios have also been closely examined to assess the impact on borrowers’ financials. “As one might suspect, an increase in covenant breaches has been observed, which often leads to difficult conversations on how to cure such contractual breaches,” notes Baruffaldi. In situations where common ground cannot be found, contractual protections are being enforced which could precipitate the takeover of collateral.
The use of payments-in-kind features is also on the rise according to Raffa, and while “historically this would have been viewed as a red flag, in the current high interest rate environment it is being used for well-performing businesses owned by blue-chip managers as a capital structure management tool.”
As rates are set to stay higher for longer and corporate earnings could struggle in the coming year, private debt could be set for a more difficult 2024. Companies that were able to apply loan extensions are now finding the cost of servicing debt far more severe than in the past, and likely needed to use cash on hand to bring down the loan value. With pricier debt, extending operations via taking on additional loans will likely be pared as firms look to concentrate on existing operations.
That being said, certain sub-sectors of the industry could be set to buck the trend due to these market dynamics. “As doubt glooms over the market, companies will tend to be more conservative in their assumptions and leverage their business less. In that sense, the market will likely shift more heavily towards big senior financing with lower loan-to-value ratios, to the detriment of mezzanine lending that is riskier,” according to Baruffaldi.
The collateralised loan obligation market in Europe has had somewhat of a topsy-turvy year in 2023 thus far. “After a strong start, with 18 deals pricing from mid-January to March, the market was spooked by the collapses of SVB and Credit Suisse,” according to Raffa. Deals have only picked up slightly, with a notably light amount of print and sprint transactions. “This reflects investors’ increasingly cautious approach, fearful that if they buy into an empty portfolio the asset sourcing process could be derailed if loan prices rise,” continues Raffa.
Looking towards next year, given the increased default probability some managers are fundraising for both traded CLOs and distressed debt. There are a number of reasons for this, however two stand out to Baruffaldi. Some are simply trying to time the market to sell loans at a higher price should the market normalise. Others “intend to use the money as an entry point to the equity, meaning they buy the debt at a low price to take over an asset at a sharply discounted price.”
The ability of private debt funds to lend efficiently, without the time drag that stems from multiple credit committees means that these funds are able to seize opportunities rapidly and make credit available to borrowers at attractive pricing levels. As banks increasingly move to a risk-on mode, private bank funds are able to pick up the slack in this area and provide more bespoke and novel forms of capital raising for businesses. That being said, while the market has seen rapid growth following the global financial crisis, economic headwinds persist and loan books could see stress as an increasing number of businesses struggle in the coming years.