Private Credit Insights – August 2022

Today’s financial headlines are typically dominated by the same few themes: inflation, rising interest rates, and recession risk.

Inflation hit 9.1% in June 2022, the federal funds rate target is now 2.252.50%, and the US economy witnessed two quarters of consecutive contractions. Additional risks, including Russia’s invasion of Ukraine, China’s continued zero-COVID policy, and their subsequent impacts on energy and global supply chains, further complicate the overall economic environment. These headlines have rippled through the M&A and financing markets resulting in higher interest expense burdens, lower leverage multiples, and a renewed focus on credit agreement documentation and terms.

In this extraordinary time of market transition, private credit is uniquely positioned to remain resilient and capitalize on compelling investment opportunities and higher returns generated by volatility and dislocations in the public markets.

Resiliency across Cycles

By design, private credit is positioned to maintain resiliency through both recessionary and rising rate environments.

In a recessionary environment, private credit has the benefit of being senior within a borrower’s capital structure and having directly negotiated credit agreements that offer tighter terms and superior covenant protections. In addition, private credit investors often have hands-on monitoring and portfolio management capabilities that tend to be more partnership-oriented in supporting borrowers through periods of credit and business dislocation. Private equity sponsorship further provides additional dry powder to support the business as well as guidance to management on how best to navigate choppy economic waters.

During rising rate environments, private credit directly benefits from an increasing base rate given its focus on floating-rate debt securities, which typically resets every one, three, or six months at the higher market rate. Today’s period of volatility and dislocation has also introduced higher spreads and higher original issue discounts (lower prices), which accrue on top of the higher base rate and typical illiquidity premium, resulting in compelling absolute returns for the asset class

Opportunity in Volatility

Rising interest rates, recessions fears, persistent inflation, and geopolitical risks have put the primary and secondary public leveraged loan and high yield bond markets under significant pricing pressure. Subsequently, banks are struggling to offload billions of dollars of hung deals that were committed to prior to the current period of volatility. Estimates of the magnitude of hung deals on bank balance sheets have been at $100 billion or higher.

Faced with several unpalatable options to cleanse their balance sheets, banks have been selling leveraged loans and high yield bonds at significant discounts, resulting in deep losses to their bottom line. While banks have been preoccupied with offloading their hung deals and sitting on the sidelines, private credit deal flow and origination volumes continued to hit record levels with the highest quarterly origination volume to date in 2Q 2022. Not only has private credit stepped in to directly finance transactions neglected by the public capital markets, private credit has also become an opportunistic buyer of the deeply discounted loans and bonds that banks have been desperately trying to sell.

Current Market Trends

Against this uncertain public market backdrop, terms for private credit investment opportunities have markedly shifted in favor of the lender. Private credit investors have witnessed lower leverage coupled with spreads increasing by 50-150 bps and OID widening by 100-200 bps on directly originated deals, on top of the increasing base rate driven by rising interest rates. Call protection has also improved, allowing private credit investors to benefit from these higher yields for a longer period of time. Credit agreement documentation terms have focused on further restricting the borrower’s ability to take on new debt or pay out dividends, which results in more cash available to service debt. This may mean tighter EBITDA definitions, more onerous financial maintenance and incurrence covenants, and limitations on restricted payments and related baskets.

Today’s volatile markets enable private credit managers to not only generate higher returns than before but also upgrade their portfolio’s credit quality while doing so. Capital structures and terms are improving for lenders not only in new issuances but also in add-on transactions supporting existing portfolio companies. Industries and companies are being scrutinized with less cyclical, recession resilient businesses being favored over more cyclical ones. Fewer dividend recapitalization transactions are being completed and unfunded DDTLs are decreasing in size and shortening in duration.

Hold sizes among many private credit lenders have also decreased, in some instances by more than half, driven in part by a slower fundraising environment. Smaller hold sizes have imbued additional investment discipline and rational behavior among private credit providers as the supply of private credit is being pulled back at the same time the demand for private credit is surging.

Private equity dry powder stands at record levels today, enabling private equity sponsors to continue to be active acquirers of businesses despite market volatility through sponsor-to-sponsor transactions, take-privates of publicly traded companies, and corporate carve-outs and divestitures. This record level of dry powder further secures a robust pipeline of opportunities for private credit to finance.

Halcyon Days

There have been many metaphors used to describe the public markets, all of which could have been used at times to describe what we have witnessed in 2022 alone: bulls, bears, dead cats, falling knives, and roller coasters. Nevertheless, in the world of private credit, these will be remembered as halcyon days.

Although private credit is not immune to supply chain challenges, inflationary burdens, slowing growth, rising rates, or other macroeconomic headwinds, it is much better equipped to withstand such pressures and deliver higher absolute and risk-adjusted returns than its investment alternatives.

Private credit managers have the ability to conduct disciplined, bottom-up credit underwriting with a focus on capital preservation, strong free cash flow generation, and robust debt service coverage. Private credit managers’ investment horizons are long, as they hold onto their privately originated loans and remain more insulated from public market price fluctuations. Structural seniority, stronger investor protections, tighter documentation, and proactive portfolio monitoring allow private credit to remain resilient in light of recessionary pressures while reaping the rewards of higher spreads and higher interest rates.

While today’s volatile markets are proving private credit’s value proposition of financing certainty to private equity sponsors and borrowers, the higher absolute and risk-adjusted returns being generated are validating private credit’s attractiveness to limited partners and other investors in the asset class.

Contact Information

Crescent Capital Group LP
11100 Santa Monica Boulevard, Suite 2000
Los Angeles, CA 90025
Tel: (310) 235-5901
Email: investor.relations@crescentcap.com

About Crescent

Crescent Capital is a global credit investment manager with approximately $39 billion+ of assets under management. For over 30 years, the firm has focused on below investment grade credit through strategies that invest in marketable and privately originated debt securities including senior bank loans, high yield bonds, and private senior, unitranche, and junior debt securities. Crescent Capital is headquartered in Los Angeles with offices in New York, Boston, Chicago and London and more than 200 employees globally.

Legal Information and Disclosures

This document expresses the views of the author as of the date indicated and such views are subject to change without notice. Neither the author nor Crescent Capital Group LP (“Crescent) has any duty or obligation to update the information contained herein. Further, Crescent makes no representation, and it should not be assumed, that past investment performance is an indication of future results.

Crescent makes this document available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Nor is the information intended to be nor should it be construed to be investment advice. Certain information contained herein concerning economic trends and performance may be based on or derived from information provided by independent third-party sources. The author and Crescent believe that the sources from which such information has been obtained are reliable; however, neither can guarantee the accuracy of such information nor have independently verified the accuracy or completeness of such information or the assumptions on which such information is based.

This document, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Crescent.