In this Q&A, Adam Wheeler, Co-Head of Global Private Finance at Barings, describes how the challenging backdrop is impacting private credit, and where opportunities may arise going forward.
What are the key challenges facing the private credit market, and what dynamics are shaping middle market lending today?
One of the big questions today is how portfolios are holding up. While manager performance can look similar during the good times, I think what we’re going to see in the year ahead—as the challenges being discussed today materialize in private market portfolios—is much greater differentiation in performance. This is because no manager’s portfolio is the same; every manager sources different assets, meaning no risk profiles look alike.
In terms of dynamics in the market, after Russia invaded Ukraine and the syndicated markets essentially shut down in terms of new issuance, private equity firms turned increasingly to direct lending to source debt for transactions. While pricing in the market did not move much initially, we are now seeing a real repricing of risk—and commensurate with that, a change in terms, conditions and leverage to compensate for the different market conditions we’re now living in.
One of the benefits of investing in private credit is the potential risk premium that stems from the illiquidity risk relative to liquid loans—but the steep price discounts in public markets today effectively show parity from a yield perspective between public and private assets. Why would an investor choose to allocate to private credit today instead of waiting until that dynamic reverts?
Private credit managers build portfolios over time, with the goal of delivering a consistent return through economic cycles. Ultimately, the way to do that is by avoiding losing capital. This asset class is driven by fundamental performance rather than by technical factors like you see in public markets. And again, what is happening now in the private market is that pricing, leverage and terms are improving, and we are seeing stronger covenant packages in loan documents. We believe these conditions will persist over the tenure of all the transactions we’re investing in, suggesting we may be setting ourselves up for outperformance over the next one to three years.
It is also worth noting that private credit is different than public markets in that loans cannot be traded on an exchange or sourced from one or two central locations. Rather, most transactions in this space are sourced through private equity sponsors and negotiated directly with the sponsor or issuing company. For this reason, having a strong origination or sourcing platform is critical to gaining access to the most attractive deal flow and then converting those opportunities into investments. This is also a buy-and-hold asset class, meaning there is limited to no ability to sell out of a position. For these reasons, we focus on investing in companies that we believe have a reason to exist through all parts of a cycle, and we take a fairly conservative approach to deploying capital. We build portfolios on a deal-by-deal basis, which means we can also be highly diversified.
Given the cataclysmic change in rates from a year ago to today, which has had significant implications for borrowers, how are you approaching the market?
One dynamic that looks likely to unfold is a transfer of return from private equity to credit as we start to see underperformance from private equity. Private credit should benefit from rising base rates, but the key will still be asset selection and avoiding losses. The next four to eight months are going to be interesting—it will be a difficult external environment, likely characterized by softening demand, eroding margins, less cash flow, and less serviceability. In our view, this sets the stage for a reset in multiples of businesses from an equity perspective, which we have not yet seen.
That said, we expect many private equity firms to provide capital support to their transactions, their businesses. But managers also need to be in the position of picking the right businesses—and they need to be willing and able to take ownership of those businesses if they underperform, manage them through their challenges, and ultimately sell them to get a recovery.
This piece was adapted from a virtual panel discussion. Read the full roundtable here.
For Professional Investors / Institutional only. This document should not be distributed to or relied on by Retail / Individual Investors. Any forecasts in this material are based upon Barings opinion of the market at the date of preparation and are subject to change without notice, dependent upon many factors. Any prediction, projection or forecast is not necessarily indicative of the future or likely performance. Investment involves risk. The value of any investments and any income generated may go down as well as up and is not guaranteed by Barings or any other person. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
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