Yes. Despite elevated macro uncertainty, it is an opportune time to allocate to private credit. Rising interest rates, reduced competition from traditional lenders, and improving documentation mean these should be attractive vintages for direct lending. In a similar vein, credit opportunities funds are finding rich pickings thanks to growing risk aversion, rising distress, and the closure of alternative funding sources.
Most risk assets posted healthy first-half returns, but subdued deal volumes belie the “risk on” narrative. Loan issuance volumes have plunged from pre-pandemic levels, in part because banks, flummoxed by recent failures and concerns over commercial real estate portfolios, continue to retreat from lending. Markets seem at an impasse, with buyers convinced that mounting macro risks should mean wider spreads, while issuers struggle to adapt to the reality of higher financing costs and hope relief from the Federal Reserve is (eventually) forthcoming.
Private credit funds are benefiting, as not all borrowers have the luxury of time. Direct lending funds can often earn yields above 12% in new loans, given a combination of elevated SOFR (around 5%), wider spreads, and original issue discounts. Reduced competition from banks means loan covenants have improved, leverage levels have dropped, and some of the other bad practices of recent years are slowly retreating. Choppy new issue markets make issuers more inclined to pay a premium for certainty of execution in the private markets, and the opportunity set for investors is expanding as larger private credit funds increase their ability to underwrite larger deals.
Credit opportunity funds, whose remit can vary from buying existing securities in the secondary market to providing new debt and equity finance to struggling companies, also seem well positioned. In recent years, many companies took advantage of low interest rates and loose lending standards to take on leverage levels that some are struggling to grow into, given slowing economic growth and elevated interest rates. Rising distress ratios and rating agency downgrade ratios highlight the growing opportunity set. Companies struggling with debt servicing ability may not find public markets receptive to refinancing as loans mature (especially where credit ratings have been downgraded). Credit opportunity funds can provide structured solutions that may include lower coupon payments in exchange for providing equity upside to lenders.
Private credit should not be considered a “beta” play. Private credit default rates typically track those of public instruments, and the latter are moving higher. JP Morgan reports the trailing 12-month default rate for US leveraged loans hit a two-year high of 2.94% at the end of June. We expect this rate to move higher given softening economic growth and rising rates. Meanwhile, recovery rates are declining, in part because weak loan and bond documentation has allowed struggling borrowers to transfer assets and burn through resources before returning to the bargaining table with creditors.
Investors that have partnered with skilled underwriters should see lower future defaults. On the lending side, detailed due diligence and favorable documentation will continue to provide a cushion if conditions deteriorate. Investors should also look for lenders in less-trafficked parts of the market (e.g., non-sponsored middle market) where negotiating leverage is stronger. On the capital opportunities side, deal sourcing capability is important, as is the ability of a manager to lead a restructuring and help operate a business if a worst-case scenario unfolds. The lack of a widespread default cycle in recent years means some firms may be under-resourced, and the value of experience can’t be overstated.
How should investors without policy targets to private credit think about funding an allocation? In our experience, direct lending strategies can complement diversifying portfolios, as their high-income levels and diversified collateral pools help smooth returns. Credit opportunity funds aiming for higher returns through discounted security pricing or adding equity-like upside to new loans can help smooth J-curves for private investment portfolios and allow capital to quickly be put to work. However, investors should recognize being higher in the capital structure through a full cycle may generate lower returns than higher-risk private equity and venture capital investments.
Wade O’Brien, Managing Director, Capital Markets Research