As The Office’s Michael Scott said, “I’m going through a little bit of a rough patch. The whole year, actually.”
He may as well have been describing 2022 for the syndicated loan market. After a respectable start, new-issue volume plummeted. It never recovered.
For private credit, the mood is brighter. The asset class has continued to take market share from other financing sources. Yields are higher than they have been for years.
In 2023, private credit providers say they expect favorable trends, regarding the opportunity set and yields, to continue.
Top of mind, headed into the new year, is the question of when the syndicated loan market will make a comeback.
There’s no doubt syndicated lenders are still smarting from Citrix, a loan transaction caught in the market tumult of 2022. The take-private LBO, a transaction valued at $16.5 billion including debt, was announced in January 2022. Banks struggled to bring it to market before pricing the company’s $4.05 billion term loan to yield over 10%, with a deeper discount than initial guidance, in late September.
“Private credit may maintain its current strong position for a while,” said Brad Marshall, who is head of North America Private Credit at Blackstone.
“For the public markets to restart, we need the CLO market to accelerate, which may take some time,” said Marshall.
In a sign of confidence heading into the new year about the private credit market’s strength, even as financial markets remain volatile, two take-private buyouts funded with private debt were recently announced, Thoma Bravo’s acquisition of Coupa Software and Advent International’s purchase of Maxar Technologies.
“Banks’ risk appetite is reduced due to losses, which may mean it takes longer for the banks to come back in a sizeable way. They could come back and do one or two deals, but likely not a bunch at one time, due to a risk management perspective,” said David Flannery, Vista Credit Partners president. “This dynamic has [created] and will continue to create a huge deployment opportunity for private credit that will likely extend well into 2023, if not longer.”
Expanded opportunities
Evidence is mounting over the degree to which private debt has absorbed transactions that had been the realm of the syndicated loan market. Beginning in March, after Russia’s invasion of Ukraine and inflation data that set the stage for hefty Fed rate hikes, the syndicated market effectively closed. Extreme market volatility sent secondary loan prices plunging, further de-incentivizing new issuance.
The absence of syndicated financing options left a void that private debt providers gladly stepped in to fill. For years, private lenders had marketed the private loan’s efficient structure, with a single group of lenders and a smaller number of them. The bear market conditions of 2022 provided an ideal test. Market dislocation meant broadly syndicated loan alternatives — which typically had been cheaper than private debt — were suddenly unavailable.
Private credit providers, flush with capital, were able to offer loans, initially at yields not too far off those available before to the volatility began.
One reason was that pandemic-era monetary stimulus had pushed global interest rates lower, prompting investors to turn to private credit for more attractive yields than other fixed-income asset classes offered. What’s more, the pandemic-induced market collapse in 2020 provided data points on private credit’s returns and defaults, becoming a further selling point for the asset class’s durability.
Starting around mid-year 2022, private credit spreads widened and loan documentation terms tightened, moving more closely to those offered in the syndicated loan market. Large loan sizes were harder to come by.
Indeed, around the end of the second quarter of 2022, the private credit market claimed it had succeeded in taking nearly 100% of market share of large buyout financings that usually would have gone to syndicated lenders. There are even signs that private credit lenders have provided financing that previously would have been done in the high-yield market. The private credit market has also been willing to provide structures unavailable in the syndicated loan market, such as financing underwritten on recurring revenue, rather than EBITDA.
The migration of deals into the private credit market, away from syndicated loans, accelerated a trend that began after the Global Financial Crisis, when increased banking regulation led to the rise of private credit, which has become increasingly standard in investment portfolios as an alternative asset.
In research published in December, KKR said recent correlation between stocks and bonds had upended traditional ideas about the balance between equities and fixed-income investments, away from the standard 60/40 portfolio, and highlighted the benefits of adding a 30% allocation to alternatives.
“Within the 30% ‘alternatives sleeve’ of that portfolio, given the recent pullback, we now have even higher conviction that allocators of capital can reap benefits by shifting to 10% Private Credit,” KKR said in a Dec. 13 research report.
“Now is the time to rethink approaches to asset allocation, including re-underwriting one’s traditional fixed income allocation, to add meaningful return and diversification in a world where there is potential for a higher ‘resting heart rate’ for inflation,” said the report, entitled “Regime Change: The Benefits of Private Credit in the ‘Traditional’ Portfolio.”
A research note from BofA Securities said that in 2022, private debt experienced the biggest leap forward in its history as the syndicated loan market turned risk averse. Most agree with BofA Securities’ assessment that private credit is here to stay as a vital part of corporate credit.
“The asset class has become an indispensable source of funding for issuers and yield for investors,” said the note on global loan markets, published on Nov. 20.
The BofA report said that private debt has gone from providing 2% of capital borrowed by leveraged companies in 2012 to over 20% in the year to date.
“The changes that have led to the rise of the asset class are structural — going forward we can expect cyclicality but not reversal of growth,” the BofA Securities note said.
Juicy yields
In addition to the growing opportunity set, it’s also a great time to be a lender from an interest-rate perspective. After years of spread tightening, leverage increasing and loan covenants loosening, the market has turned lender friendly.
Lenders are firmly in the driver’s seat going into 2023, with financing across industries harder to come by for borrowers large and small. Buy-and-hold sizes that lenders are offering have shrunk, increasing the number of lenders needed to provide a given financing package. Gone are the days when lenders are touting the sizes of loans they are able, and willing, to provide.
In fact, based on private credit deals tracked by LCD, the share of LBO transactions with only one lender declined to 55% in the fourth quarter of 2022, from 86% in the first quarter of 2022. At the same time, leveraged buyouts funded with private loans that had three or more lenders increased to 28%, from 3%.
This has helped lead to yields levels that were mostly unattainable in the borrower-friendly conditions of recent years.
A growing chorus of financing providers say they expect yields of 12% on new loans to be commonplace next year, based on a spread of Sofr+650 and a base rate of 5%. For comparison, a loan coupon of Sofr+550 (1% floor) was typical on a private loan prior to the market volatility that began in the first quarter of 2022. As of January, the average spread for broadly syndicated term loans from B/B+ issuers was 374 bps, and the average yield was 4.43%.
“On an absolute basis, first-lien yields are the highest we have seen in more than a decade,” said Mitch Goldstein, co-head of Ares Credit Group, in a third-quarter earnings call. “We believe that the current market environment offers attractive opportunities, but it takes a disciplined, scaled and stable capital provider to be able to capitalize on that.”
Defaults, too
Away from these positive trends, private credit providers are nearly certain to experience more defaults and credit losses next year as well. These could dampen the mood in 2023.
According to one measure of credit stress, Proskauer’s Private Credit Default Index showed a default rate of 1.56% at the end of the third quarter of 2022, versus 1.18% in the second quarter. Proskauer said this was the first “notable increase” in private credit defaults over the past 18 months. For comparison, the default rate of the Proskauer Private Credit Default Index peaked at 8.1% in the second quarter of 2020.
BofA Securities said private credit portfolio defaults could exceed 5%, with the potential for high single digits by late 2023 or early 2024. The estimate is based on a historic relationship between private debt credit risk and risk in the syndicated loan market, BofA Securities said. Smaller companies are expected to bear most of the pain. The BofA research defined lower middle market companies as those generating less than $50 million of annual EBITDA.
Private credit providers openly acknowledge the challenges ahead as borrowing costs rise, the economy slows and elevated input costs weigh on margins of portfolio companies. Lenders are partly relying on lessons learned in 2020, during the depths of pandemic uncertainty, about amendments and give-and-take available from private equity sponsors with whom one lender might have several deals.
So far, private credit providers say expected headwinds in 2023 will be manageable. Already, they are focused increasingly on portfolio management. Echoing this sentiment, Oaktree noted increased conservatism among middle market direct lenders.
“As the economy has weakened and yields have risen, direct lenders have not only become less willing to finance new companies, but they’ve also become less apt to extend additional capital to their existing portfolio companies unless they receive higher pricing on all of their exposure,” said Oaktree in a year-end quarterly newsletter.
“We suspect that the portfolios of many direct lenders are beginning to show signs of weakness, as midsized companies in many sectors are reporting declining revenue and narrower profit margins, due to the rising cost of wages, raw materials, freight, and other inputs,” the fourth-quarter publication said.
Focus on CLOs, add-ons, stressed opportunities in 2023
Despite robust issuance levels in 2022, market participants have been challenged to make the “arb” on deals due to spreads that sharply widened from the first quarter — including more than 100 bps on average for the first-pay triple-A tranches. Institutional investor demand was muted in the risk-off environment, and falling leveraged loan issuance made managers often dependent on discount offerings in the secondary market to push deals through to pricing.
The rising levels of low-rated assets in CLOs in 2022 has heightened concern on what an expected downgrade wave among loan assets in 2023 will mean for CLO performance — particularly for mezzanine and equity slices of deals if cash flow is diminished or diverted.
In terms of new-issue opportunities, add-on acquisitions will be an important source of private debt activity now that valuations have tumbled from the peak levels of late 2020 and early 2021.
“Buying new investment platforms could be much more expensive than finding well-priced, smaller companies, that could be underperforming, to fold in and be accretive, over time,” said Dean D’Angelo, partner at Stellus Capital Management.
“Capital is becoming expensive and scarce. Deals are still getting done, but this dynamic will most likely put a damper on the number of deals done in 2023. Lenders with available capital should be able to find some very interesting opportunities,” D’Angelo said.
Also notable in 2023, private credit will likely be a solution for stressed syndicated loan issues.
“We believe that the presence of PD (private debt) capital is likely to stave off some default pressures for BSL issuers in the next default cycle. All things equal, it provides an additional avenue of securing financing, albeit at higher costs. As the economy falters and liquidity pressures build up amongst lower quality HY and loan issuers, some could avoid defaults by financing themselves in private markets,” the BofA Securities note said.
“We expect that PD platforms would welcome another opportunity to ‘trade up’, just as they did earlier this year. This pool of capital, given its long-term, non-mark-to-market nature, has the potential to act as a shock-absorber within credit markets,” BofA Securities said.
But there’s little doubt 2023 will be an interesting year for the growing asset class.
“2023 won’t be boring, at the risk of being accused of being an optimist,” said Monroe Capital co-portfolio manager Chris Lund. “For lenders that do have dry powder, and have a successful track record in past downturns, this should present an opportunity of higher returns. … The 2023 vintage for the middle market should be the most exciting that we’ve seen in over five years.”
“The US middle market is large and highly fragmented with a lot of good investment opportunities in any market cycle. Maybe we will operate through a recession next year, but there will always be businesses looking for institutional capital, or to acquire a competitor, even if there’s a downturn, to show growth,” said Lund.
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