Private credit: Is now a good time to invest
As we approach the eighth year of economic recovery, headlines abound on whether or not a recession is near and what may cause it. Risk-taking appears to be on the rise not only in the equity markets but also in the credit markets. Identifying these potential risks and how they might impact the prevailing investment opportunity in private credit is a topic that has been on our minds, and it is one we believe is relevant to our clients, particularly given the increased level of investor activity we are seeing in the private credit space.
Credit fundamentals appear to be weakening, although there are divergent views. Covenant-lite deals (i.e. ones where investors are willing to forego maintenance covenants that provide for regular enforcements with respect to the company’s free cash flow, debt to equity ratio, etc.) hit an all-time peak of 73% in 2016 and represent 70% of total loan issuance for the H1 2017 according to Credit Suisse and S&P LCD. Most market sources view covenant-lite as an indicator of higher risk tolerance and are recommending greater caution. Covenant-lite, however, does not necessarily mean the loan is more risky than a traditional loan. Oppenheimer1 had an interesting perspective on this:
“[What is more risky?] A cov-lite deal with a debt incurrence limit of five times trailing cash flow, or a deal with traditional maintenance covenants that allow the company to leverage itself up to ten times its most recent quarter’s annualized cash flow?”
Regardless of which side you take on this topic, the increase in covenant-lite issuance does suggest we are experiencing a very strong credit market driven by robust investor demand and a willingness to accept less covenant-heavy deals.
The weakening of credit fundamentals may also forewarn an increase in risk-taking. Triple C high-yield bond (HY CCC) and 2nd lien leveraged loan (2nd lien) issuance has increased to 17% and 5% in 1H 2017 from 11% and 3% in 2016, respectively, but still lags the proportions seen in 2007 (i.e. 21% for HY CCC and 8% for 2nd lien)2.
Credit spreads are also tightening, signaling that investors are willing to take on more risk without a commensurate increase in return, which could be a sign that higher volatility lies ahead. Eventually, this tends to lead to a cycle in which a higher number of less creditworthy companies access the credit markets, leading to a higher proportion of defaults and widening credit spreads.
High-yield (HY) and loan issuance for leveraged buyouts (LBO) has been on the rise since 2009 but is nowhere near the peak levels reached in 2007 and 2008. On the one hand, a commonly held view is that the current market, as a corollary, is characterized by less aggressively structured deals with more investor-friendly terms, since HY and loan LBO issuance is more attenuated today than during the 2007 to 2008 peak; we do not necessarily agree. It could suggest that other private capital sources are providing an increasing amount of the leverage for buyouts and refinancings, including direct lending fund managers, uni-tranche providers, regional banks, directly originated transactions from LPs with private lending teams, as well as fund managers targeting subordinated debt solutions.
While the aforementioned trends in the larger end of the broadly syndicated market may not directly correlate to the private credit market, these trends do suggest that we are in a period where the credit markets have a lot of momentum and more risk-taking appears to be occurring.
Private Credit Strategies
Private credit is a broad term that encompasses a large opportunity set representing an estimated $4 trillion market3. We view private credit as encompassing two primary categories: Direct Lending and Special Situations. These categories are composed of various distinct strategies as summarized in Table 1.
Compared to 10 years ago, the areas we have seen the largest relative increase in LP demand and fundraising activity are in the senior secured direct lending (direct lending), structured credit and opportunistic segments. Of these three, however, direct lending has received increasing attention from LPs, with more than 230 funds having closed on more than $130 billion of capital since 20134. This compares to a market opportunity of approximately $550 billion according to Carlyle and represents a significant increase from approximately $23 billion raised between 2009 and 2012. The primary catalyst for this increase in demand is historically low returns on public fixed income securities over a sustained period (see Graph 1).
Inquiries or comments concerning this article may be addressed to:
Pavilion Alternatives Group, LLC.
1 – “Cov-Lite” Senior Loans: Much Ado About (Almost) Nothing, Oppenheimer Funds, July 25, 2017.
2 – CS Credit Strategy Daily Comment – Leveraged Finance. Credit Suisse. August 15, 2017.
Disclaimer: This material contains proprietary and confidential information of Pavilion Advisory Group Inc. (“Pavilion”) and is intended for the exclusive use of the parties to whom it is provided. The opinions contained within this document are those of Pavilion and is subject to change based on changes in the firm’s opinions and other factors such as changes in market or economic conditions. Pavilion has relied on the use of third-parties in the preparation of this material. While we believe our sources to be reliable, we cannot be liable for third-party errors or omissions. The information should not be construed as an offer to sell or the solicitation of an offer to buy any security and does not constitute investment advice. The content herein is intended solely for the recipient and not for broader distribution. Investing involves risk, including the loss of principal invested. Past performance is no guarantee of future results. You should carefully review and consider the applicable prospectus or other offering documents prior to making any investment. Pavilion Advisory Group is a registered trademark of Pavilion Financial Corporation used under license by Pavilion Advisory Group Ltd.in Canada and Pavilion Advisory Group Inc. in the United States. Pavilion Advisory Group Inc. is a U.S. based investment adviser registered with the U.S. Securities and Exchange Commission. Pavilion Advisory Group Ltd., our Canadian affiliate, is an investment advisor registered with the securities commissions of various Canadian provinces. © 2017 Pavilion Financial Corporation. All rights reserved.