Despite the escalating macroeconomic uncertainty, the current climate presents a potential opportunity for investors to allocate to private credit. The combination of rising interest rates, dwindling competition from traditional lenders, and higher covenant protection are al supportive of attractive private credit returns.
Subdued Deal Volumes
While most risk assets reported robust returns in the first half, the subdued deal volumes contradict the prevailing "risk on" narrative. Loan issuance volumes have plummeted from pre-pandemic levels, partly due to banks retreating from lending, confounded by recent failures and apprehensions over commercial real estate portfolios. The market appears to be at a standstill, with buyers insisting that mounting macro risks should translate to wider spreads, while issuers grapple with the reality of higher financing costs and pin their hopes on potential relief from the Federal Reserve.
The Rising Role of Private Credit Funds
Private credit funds are reaping the benefits as not all borrowers can afford to wait. Direct lending funds can often secure yields above 12% on new loans, thanks to a combination of elevated SOFR (around 5%), wider spreads, and original issue discounts. Less competition from banks has led to improved loan covenants and reduced leverage levels. The challenging new issue markets are prompting issuers to pay a premium for certainty of execution in private markets, thereby expanding the opportunity set for investors as larger private credit funds enhance their capacity to underwrite bigger deals.
Positioning of Credit Opportunity Funds
Credit opportunity funds, which can range from purchasing existing securities in the secondary market to providing new debt and equity finance to struggling companies, also appear well-positioned. In recent years, many companies exploited low interest rates and lax lending standards to take on leverage levels that some are struggling to sustain, given the slowing economic growth and rising interest rates. The increasing distress ratios and rating agency downgrade ratios underscore the growing opportunity set.
Companies grappling with debt servicing ability may find public markets unreceptive to refinancing as loans mature, particularly where credit ratings have been downgraded. Credit opportunity funds can offer structured solutions that may include lower coupon payments in exchange for providing equity upside to lenders.
Challenges: Rising Default Rates and Declining Recovery Rates
However, private credit should not be viewed as a "beta" play. Private credit default rates typically mirror those of public instruments, and the latter are on the rise. JP Morgan reports that the trailing 12-month default rate for US leveraged loans recently reached a two-year high of 2.94% and this is expected to increase given the softening economic growth and rising rates. Meanwhile, recovery rates are declining, partly because weak loan and bond documentation has enabled struggling borrowers to transfer assets and deplete resources before renegotiating with creditors.
The Importance of Partnering with Skilled Underwriters
Investors who have partnered with skilled underwriters should anticipate lower future defaults. On the lending side, detailed due diligence and favorable documentation will continue to provide a safety net if conditions worsen. Investors should also seek lenders in less-explored parts of the market (e.g., non-sponsored middle market) where negotiating leverage is stronger.
On the capital opportunities side, deal sourcing capability is crucial, as is a manager's ability to lead a restructuring and assist in operating a business if a worst-case scenario unfolds. The absence of a widespread default cycle in recent years means some firms may be under-resourced, and the value of experience cannot be overstated.
Our Outlook Remains Stable
Based on our experience, direct lending strategies can complement diversifying portfolios, as their high-income levels and diversified collateral pools help stabilize returns. Credit opportunity funds aiming for higher returns through discounted security pricing or adding equity-like upside to new loans can help smooth J-curves for private investment portfolios and allow capital to be quickly deployed. However, investors should recognize that being higher in the capital structure through a full cycle may yield lower returns than higher-risk private equity and venture capital investments.