Fiddich Review Centre
Alternative Investment

Private debt outlook 2023: Risk and opportunity co-exist

While private debt deal flow and fundraising pace have slowed from last year’s records, the industry still ended this year on solid footing.

But 2023, which is expected to be a tumultuous year, will present the industry with a series of challenges, including persistent inflation, a backdrop of higher interest rates and the prospect of slower economic growth.

Anticipating greater uncertainty in the economy and more rate hikes from the Federal Reserve, investors still view private debt as attractive because of the asset class’s ability to generate contractual returns, produce a higher yield premium in a rising-rate environment and offer a suite of diversified strategies that can work under varied market conditions, industry experts say.

“There is so much diversity in this asset class, which means investors will have plenty to do regardless of market conditions,” said Robert Molina, the head of origination from Briarcliffe Credit Partners.

“If you think about benign markets, you can invest in direct lending. If you think about challenging markets, you have distressed debt and others. We have identified 26 strategies within private credit, which allows this asset class to be relevant in any market condition.”

KKR’s analysts, meanwhile, recommend that investors shift a portion of traditional 60/40 portfolios to alternative investments, including private credit, in an effort to improve returns and reduce risk as they navigate through a “new macroeconomic regime” next year, according to the firm’s latest midyear macro outlook report.

The firm suggests LPs progressively increase private credit holdings to 10% of their overall portfolio, taking advantage of floating-rate assets to help generate more income.

However, market volatility and heightened expectations for an economic downturn or recession mean that investors will want more downside protections for their private credit investments. Industry experts who spoke with PitchBook outlined three themes that can meet investors’ needs for diversification and risk yield.

Lower middle-market deals may provide greater protection in a downturn

While private credit encompasses a wide range of strategies, the most common one—and where the bulk of private debt capital goes to—is direct lending. Direct lenders originate private corporate loans, which are typically structured so that lenders will get repaid first if a borrower defaults.

Given the historical performance of these loans, the middle-market segment—which refers to companies with EBITDA below $50 million—generally yields better returns in a market downturn than the large-cap market, said Mark Perry, the head of alternative managers research at Wilshire Associates, an investment advisory firm.

That is because underwriting for middle-market lending tends to be stricter and lenders push for more stringent deal terms that would offer stronger protection when the credit underperforms, he said. That means these deals tend to be negotiated on lower debt-to-EBITDA multiples, greater equity cushion and less covenant flexibility.

Direct lenders have been asking for tighter covenants compared to lenders in the broadly syndicated loans market. In particular, they demand protected terms regarding “restricted payments, debt incurrence, financial maintenance tests and EBITDA adjustments,” according to an analysis by Latham & Watkins deal attorneys Karan Chopra, Dan Seale and Alfred Xue.

As competition in the space has picked up in recent years, direct lenders have been showing a greater willingness to provide loans with fewer restrictions on borrowers, especially when they are competing for bigger deals. However, lenders in the lower end of the market are still pushing for more restrictive terms.

Those terms are put in place to guard the investment in a downside scenario, and investors will lean on these stronger covenants if market performance weakens next year, Perry said.

Opportunistic credit to shine amid market volatility  

Investors have also been increasingly looking at opportunistic credit as they search for ways to maximize returns in a market downturn.

This strategy may mean different things to different investors depending on how mandates are defined, but it mainly involves investing in primary and secondary opportunities across the credit spectrum and providing bridge or rescue financing to cash-hungry companies.

“We like opportunistic credit as we think there is an all-weather nature to this strategy,” Perry said.

Managers can flexibly switch from making loans to cash-strapped companies to trading stressed and distressed debt in the secondary market, he added.

A number of credit managers in recent months have launched or wrapped up funds targeting opportunistic investments in credit markets. European manager Arcmont Asset Management, for instance, closed a fund in September at €800 million (about $848 million), targeting this strategy. Pemberton Asset Management and Hayfin Capital Management have also reportedly raised similar funds.

Erol Uzumeri, co-founder of Searchlight Capital Partners, said he is seeing a lot of favorable opportunities right now where investors can buy underperforming credits at steep discounts from business development companies, fund managers and banks that are under pressure to strengthen liquidity.

In particular, there are more stressed and distressed opportunities in European markets, where the economy was battered by a string of challenges from energy crisis to war, according to Uzumeri.

Searchlight is currently deploying capital out of its second fund to target these investments, and a lot of credits they have acquired were trading in the ’70s, he said.

“Right now, where LPs are leaning into private credit and picking their spots is in areas like opportunistic credit, distressed debt and senior debt,” said Nayef Perry, the co-head of direct credit at Hamilton Lane.

Exotic strategies provide a diversified set of uncorrelated returns

The private credit market captures a wide range of substrategies also expected to gain traction among investors in 2023.

As investors look to build diversified portfolios and mitigate risk in a choppy market, they also keep their eyes on lesser-known strategies within the private credit arena, including specialty finance, net asset value loans, asset-backed lending, litigation finance and music royalties. Some of those assets can provide inflation protections, while others offer steady income streams that are untethered to the public markets.

“Investors’ ability to build diversification into their private credit allocations are far superior today than they were 10 years ago,” said Mark Perry, of Wilshire Associates. “As we head into a tumultuous period next year potentially, we should be taking advantage of that.”

Featured image by kudla/Shutterstock

Source link

Related posts

Retail Investors: View: How retail participation has changed the DNA of Indian markets


Insurer AIG profit slumps on hurricane costs, lower investment returns


UK Alternative Investments Rising In Popularity Amid Inflation Fears  


Leave a Comment