Taking the pulse on private credit
New deal flow has waned over the past year in a difficult M&A market and fundraising has become more challenging, so how has private credit fared?
“The pace of deployment was a challenge as the market didn’t recover as quickly as people wanted it to,” says Dan Cohn-Sfetcu, Managing Director and Portfolio Manager, Senior Credit at FS Investments. “But we saw a lot of activity in our portfolio, largely driven by private equity firms working with existing portfolio companies – there was demand here for additional capital.”
“M&A has been relatively off the pace recently,” says Mitesh Pabari, Principal, Fund Investments, at Hamilton Lane. “But the need for refinancing is still there, so private capital deployment remains at historical market averages.”
“When private equity holds on to assets for longer, it tends to be more acquisitive,” adds Joe Lazewski, Senior Managing Director and Co-Head at NXT Capital. “Nearly a third of our volume last year was add-on funding.”
Few are ready to call a thawing of the M&A market just yet, but there will come a point at which the system will grind back into action. But what will it take? “There is a lot of dry powder in private equity and private credit,” says Cohn-Sfetcu. “The key will be to get sellers to finally transact and accept that we are in a different valuation environment to what we had 24 months ago. People are now starting to accept that we are not going to revert to where we were, and there is pressure to provide liquidity to LPs so we will start to see more transactions. If we see spreads tightening and a reduction in the base rate, that may be the final catalyst in closing the gap between buyers and sellers.”
Private credit went largeThe broadly syndicated loan (BSL) market froze in early 2023, leaving a hole for large cap borrowing that private credit players were happy to fill. “Around 80% to 85% of large cap transactions used private credit last year rather than BSLs,” says Cohn-Sfetcu. And it seems that the genie is now out of the bottle. “Some of this activity will revert to the BSL market,” he adds. “But the history of private credit has been that when it enters new territory, it tends not to give it up. Borrowers become accustomed to working with private credit and enjoy the advantages of certainty of finance, customised capital structures and privacy as a borrower that you don’t get on public markets. We’ll continue to see this trend through 2024, although to a slightly lesser extent.”
Yet some are wary about this direction of travel. “As European capital markets have been choppy over the past 18 months, private credit has stepped in to finance larger transactions,” says Blair Jacobson, Partner and Co-Head of European Private Credit at Ares Management. “That’s generally good for our business, but there is some risk that these transactions look very much like BSLs – with similar documentation, but without the liquidity.
Private credit GPs therefore need to be careful about where they play in the market, how they are differentiating from traditional bank financing and what they charge, because there needs to be alpha.”
The key will be to get sellers to finally transact and accept that we are in a different valuation environment to what we had 24 months ago. People are now starting to accept that we are not going to revert to where we were, and there is pressure to provide liquidity to LPs so we will start to see more transactions.
As regulatory pressure and economic uncertainty have bitten, banks have been retrenching from many of their traditional lending markets, leaving the market clear for private credit. “We understand that banks have taken a big step back in the past 12 months, in particular, in the SME segment of the market,” says Lei Lei, Co-Head of European Credit Opportunities, Alternatives, at Ninety One.
But the banks remain keen not to be shut out entirely. “Banks need us and we need them,” says Paul Burdell, CIO at LCM Partners. He points to the range of joint venture arrangements struck up over recent times – Wells Fargo and Centerbridge, Brookfield and Societe Generale, Barclays and AGL, and Citi and Luminarx. “We’re not just a financial partner to a bank; we can be an operational partner. We can be their back office, even on a white-labelled basis. The better we are on the operational side, the better the solution for the financial institution.”
LPs have had a hard time distinguishing between the good, the bad and the ugly of the private credit world in recent years as firms could take advantage of a relatively benign environment. “There are a lot of untested direct lending managers out there,” says an investor specialising in private wealth asset management. “It’s been a benign environment with low default rates and so track records look great. It’s hard as an LP to ascertain who has selected credit well and who has written good quality covenants that will protect our capital.”
But the coming period could make the distinction much clearer. “This is a very idiosyncratic market,” says Corrado Pistarino, CIO of Foresters Friendly Society. “The past 10 years have been an easy ride for many managers and so it has been difficult as an LP to attribute any value to firms’ track records. Over the next 12 to 18 months, we’ll see a dispersion of returns across managers because of the underwriting criteria they have applied.”
