Private Credit: Optimism is in the Air
By: Ian Fowler, CFA, Barings
The private credit market is currently offering investors some of the most attractive dynamics in years—but there are also some headwinds on the horizon.
This is an excerpt from NCPERS Fall 2023 issue of PERSist, originally published October 24, 2023.
Today's private credit market is benefiting from higher base rates, attractive spreads, and a thawing origination landscape.
Earlier this year, the slowdown in high yield and broadly syndicated loan markets combined with volatility in the banking sector to create a shortage of capital in the traditional middle market. The result was that with less capital competing for deals, borrowers faced a higher cost of capital as well as improved credit documentation.
For investors, this turned out to be a good thing—in the form of higher yields and better structural protections. And it's also had the positive knock-on impact of preventing borrowers from taking on the excessive levels of leverage, leading to lower levered, more resilient capital structures.
Now, with base rates at ~5%, we are seeing all-in yields in the 10-12% range for senior “down the middle” deals with lower leverage and first-lien risk.i From a historical basis, the risk-return on offer looks extremely attractive today. These tailwinds appear to be setting up for an attractive direct lending vintage in 2023 and 2024.
There are, however, some headwinds.
Will Managers be Able to Put Capital to Work?
One of these comes down to deployment—the lifeblood of private debt. With the M&A market slower, there are fewer new deals available to private lenders.
However, for lenders with large and established portfolios, there are opportunities to generate deal flow from current portfolio companies as their private equity owners continue to execute on buy and build strategies. At Barings, our existing portfolio is generating significant deal flow for us this year—in North America, approximately 70% of our deal activity has come from the existing portfolio. This is particularly notable not just in terms of the visibility of deal flow and the ability to reliably deploy capital, but also because it does not require any sacrifices in quality to do so. These are typically accretive add-on acquisitions for companies that we have underwritten and invested in for years.
Across the market, there are also indications that the origination pipeline to support private equity firms in traditional LBO structures will look much more robust in the coming months. In other words, we think it's about to get easier to deploy capital.
The Default Picture
Another headwind comes in the form of the elevated risks of default. The higher returns that private debt enjoys, means higher interest costs for the borrowers and therefore greater pressure on margins and profitability. We are therefore likely to see an increase in defaults as a result, but these are likely to impact more highly levered businesses and more cyclical industries.
Those who have built more aggressive portfolios in the recent post-Covid ‘good times' may come to regret some of the excessive risks taken. As a result, we do expect to see a bifurcation in terms of manager performance with those more disciplined and conservative managers outperforming—but this could be a positive evolution as it will reaffirm the importance of discipline and caution in delivering a stable and defensive income.
It remains to be seen what the macro backdrop has in store, but given the yields currently on offer, along with improved structures, less leverage and a thawing origination backdrop, a variety of factors are converging that suggest that 2023 and 2024 private credit vintages could be some of the most attractive we have seen in years.
iSource: Barings' observations. As of August 9, 2023.
About the Author: Ian Fowler is Co-Head of Barings' Global Private Finance Group, a member of the group's North American, European and Asia-Pacific Private Finance Investment Committees and President of Barings BDC, Inc. (NYSE: BBDC). He is responsible for leading a team that originates, underwrites and manages global private finance investments. Ian has worked in the industry since 1988 and his experience has encompassed middle market commercial finance, including originating, underwriting and managing senior secured loans, mezzanine and co-investment transactions. Prior to joining the firm in 2012, he was a Senior Managing Director with Harbour Group and co-founded Freeport Financial LLC where he was a member of the Executive Credit Committee and responsible for all business development and capital market initiatives. Ian holds a B.A. (Honors) from the University of Western Ontario and is a member of the CFA Institute.