European private credit: An investor's update
A conversation with Michela Bariletti, Phoenix Group
Relative value opportunity. We invest in private debt as part of a multi asset credit portfolio so we find the asset class attractive based on the pick-up versus other credit with comparable credit risk.
Diversification. We also like the diversification that private credit brings to our credit portfolio, with a range of names, tenors, formats and secured positions that we would not be able to access in public credit markets.
Matches long-term liabilities. We invest to match long term cash flows and we are able to look at pricing and illiquidity premium at a point in time rather than try to time the market.
Structural benefits such as the ability to have covenants and security. Given the buy and hold nature of our business, structural benefits provide protection against downside risk and an opportunity for us to work with the borrowers when things deteriorate.
For example, infrastructure that supports net zero or the levelling up agenda for the UK. We also support several affordable housing providers in the UK as well as in Europe (France and Germany)
In volatile markets there will clearly be great opportunities for those that can be opportunistic.
Phoenix is a long-term investor focussed on high quality credit and debt instruments with strong covenants. We do look to be opportunistic in respect of allocation to sectors or markets (public versus private, primary versus secondary etc.), where we think we can pick up relative value. For instance, real estate could offer opportunities due to re-setting of valuations and pressure to sell.
Given the uncertain macro-economic backdrop, we have on average continued to favour higher credit quality with low rating transition risk. We also observe that credit spreads are currently inside their long term averages and not pricing a recessionary environment.
Therefore we currently see value in rates relative to credit. The rapid surge of interest rates (quickest pace of tightening in 45 years) is also yet to be felt by a number of fixed rate borrowers that will have to refinance debt issued in a very low interest rate environment, where we are also experiencing higher level of geopolitical risks and monitoring the pace and stickiness of the reduction in inflation.
With that in mind, Infrastructure remains an attractive asset class given its defensive nature, inflation hedge and positive exposure to structural trends (decarbonisation, digitalisation).
We also see strong relative value in long-term, inflation linked leases with high quality counterparties, which can be particularly attractive when matching insurance liabilities.
We invest across many sectors – CRE debt, infra debt, social housing, education, private corporate loans. We also invest across a range of jurisdictions – predominantly the UK, Europe and North America.
In the current environment it is important to maintain discipline on debt structures, to ensure you have adequate protections and warning mechanisms in case of credit deterioration. In the past year there has been a material re allocation to infrastructure and structured finance to fill the pause in the CREL market. This is still expected to continue.
As a long term multi credit investor we are willing to be patient, continue to apply discipline and pick up illiquidity premium through robust due-diligence on a case-by-case basis. Overall, we expect negative ratings migration and actual defaults to increase, with an expectation of quite diverse outcomes within particular sectors or ratings buckets.
As a result, we are super-selective, executing last year less than 5% of the transactions we reviewed in detail – however this detailed approach allows an investor to stay engaged across a range of sectors even in volatile markets, and can lead to attractive and strong transaction opportunities as other participants withdraw. In the current environment investing in private credits require:
Understanding idiosyncratic credit fundamentals. With an inability to easily trade out of illiquid credit, underlying credit fundamentals are fundamental to long term returns in private credit as illiquidity pick up cannot compensate for loss of capital.
Strong governance. Borrowers are challenged by disrupted supply chains, higher input costs including energy and labour expenses and their customers are under pressure.
Individual businesses will fail, service or thrive depending on their operating model, supply or customer dis/advantages, liquidity and balance sheet, plus of course quality of management. Additional consideration in current environments:
Importance of debt structures, ability to negotiate covenants and ensure robustness of transaction structures
Liquidity of co-lenders – particularly important due to extreme moves in rates, FX denominator effect, and idiosyncratic credit spreads. As seen during the Covid and the LDI crisis, the liquidity of your fellow investor can be important, as they may need to exit, and a forced sale will likely push spreads wider. On the other hand, this could lead to interesting secondary opportunities for less constrained investors
Staying close to your borrowers and ensuring frequent ongoing dialogue, especially at times of stress.
This asset class is and will remain attractive, with banks continuing to face lending constraints (e.g. Basel 4) and the ability of institutional investors to deploy in size across sectors and credit quality / structures is likely to evolve, encouraging further private issuances. The challenge is to remain disciplined when there is increasing demand from institutional investors relative to supply (e.g. some renewable assets). We note there is still a large gap in Europe vs the US regarding the proportion of non-bank lending however we could see this trend continue in new markets providing further attractive opportunities for investors. Could Asia be the next frontier?
With the current growth in mind, how do you expect investors’ appetite for private credit will develop in the next year? What risks or challenges should you factor in?
As a long term multi credit investor we are willing to be patient, continue to apply discipline and pick up illiquidity premium through robust due-diligence on a case-by-case basis.
