Industry voice: Despite risks, private credit investment opportunities are still available
Raelan Lambert, managing director at Pavilion Alternatives Group looks at the attractiveness of credit strategies available to investors in the current market.
Relative to the current market environment, credit fundamentals appear to be weakening.
Last year, covenant-lite deals hit an all-time peak at 73% of total loan issuance. The high proportion of cov-lite debt looks set to continue this year, with cov-lite loans accounting for 70% of total loan issuance in the first half of 2017, according to Credit Suisse and S&P’s Leveraged Commentary & Data.
Cov-lite is generally seen by the market to be an indicator of higher risk tolerance and as a result market sources are recommending greater caution. Credit spreads are also tightening, signalling that investors are willing to assume more risk without a commensurate increase in return expectations, which could signal higher levels of volatility ahead.
High-yield (HY) and loan issuance for leveraged buyouts has been rising since 2009, but remains nowhere near the peak levels of 2007 and 2008.
Though a common view is that the current market is characterized by less aggressively structured deals with more investor-friendly terms - since HY and leveraged loan issuance is thinner today than during the pre-crisis peaks - we see it differently at Pavilion.
Other private capital sources not widely reported in HY and leveraged loan data may be providing an increasing amount of the leverage for buyouts and refinancings. These sources could include direct lending fund managers, unitranche providers, regional banks, directly originated transactions from LPs with private lending teams as well as fund managers targeting subordinated debt solutions.
The private debt fund market has certainly expanded: the AuM of private debt fund managers has grown by a factor of four in the past decade, reaching $595bn at the end of 2016, according to Preqin. Last year, a combined $95bn was raised by 131 funds, and the fundraising pace appears to continue in 2017.
Below is Pavilion’s analysis of the opportunities different strategies offer in the current market environment.
Certain direct lending strategies appear favourable, particularly in the lower mid-market (companies with less than $40m of EBITDA). This part of the market is too small for regional banks to focus on as they are more active in providing leverage facilities to the managers raising and investing direct lending funds. For transactions completed alongside PE sponsors, this end of the market offers managers an ability to structure meaningful covenant and call protections, as well as enforcement rights.
Non-sponsored transactions are also favourable, and a less competitive market segment than the sponsored market. Return premiums also appear achievable at the larger end of the market (companies with EBITDA of $75m and up), where investors are compensated for execution and structural complexity, certainty and efficiency - particularly when a fund manager can assume the entire debt tranche.
Special situations fund managers typically embrace complex situations, meaning competition for deals is relatively less intense but where financial structuring acumen and deep knowledge of the company and sector is required.
Investments are typically structured with significant protections in order to minimize the potential for losses, and most investments include regular coupon payments and/or preferred equity structures with dividends.
We favour fund managers that possess the flexibility to invest throughout a company’s capital structure, as well as ones that can opportunistically deploy capital across economic cycles.
Fund managers that can provide liquidity quickly in situations where pockets of dislocation occur, appear an attractive investment prospect over the medium-term.
Distressed managers jump on dislocations driven by a range of factors, which may include market-specific dynamics where situational events provide an opportunity to purchase discounted debt on the secondary market in companies believed to be fundamentally sound but mispriced.
Fund managers targeting specific industry dislocations also appear well-positioned in the current market. These include a full spectrum of fund managers at both the larger and smaller end of the market that can structure capital solutions for companies to solve a balance sheet problem.
Given the change in consumer/retail dynamics, fund managers are positioning themselves to provide more bespoke solutions and restructurings or capital when debt maturities expire. The energy industry is another key target as certain businesses are in need of restructuring solutions to achieve capital structures more in line with the persistent trend of lower oil prices.
We believe private credit is an exciting and evolving segment of the private market. The manager universe continues to expand providing investors with a growing breadth and depth of opportunities to satisfy a diverse range of risk/return profiles. While risks are prevalent, this is true for any asset class, and a number of attractive opportunities remain for investors to allocate capital across the private credit spectrum.
DISCLOSURE: The opinions contained within this document are those of Pavilion Alternatives Group, LLC (Pavilion) and are subject to change based on changes in the firm’s opinions and other factors such as changes in market or economic conditions. Pavilion has relied on the use of third-parties in the preparation of this material. While we believe our sources to be reliable, we cannot be liable for third-party errors or omissions. The information should not be construed as an offer to sell or the solicitation of an offer to buy any security and does not constitute investment advice. Investing involves risk, including the loss of principal invested. Pavilion Alternatives Group, LLC is a U.S.-based investment adviser registered with the U.S. Securities and Exchange Commission. © 2017 Pavilion Alternatives Group, LLC. All rights reserved.