By Randy Schwimmer
Where are we in the cycle?” That question gets asked at every conference we attend. It’s also clearly on the mind now of every investor, arranger and issuer of debt. The reason is clear: if we are in the seventh innings of the cycle (which seems the consensus), a downturn might be around the corner.
Unfortunately, economic data is sending mixed signals on underlying US inflation and growth expectations, and the confusion is reflected in the ambivalence of investors about liquid credit. On one hand, prices of the most traded loans continue their grind higher off last year’s lows. On the other, retail cash continues to leave both loan and high-yield funds in either dribbles or droves – depending on the week. This volatility, of course, is consistent with the performance of public equities, where conviction is paper-thin. It only takes one spooky headline to send the Dow tumbling and investors fleeing.
Yet conditions for US credit remain constructive. Interest rates are low; default rates remain near historic lows; and economic growth – while hardly robust – plugs along.
Some observers believe the worst-case scenario – the end of the recovery – is not bad at all for private credit. Christopher Godfrey, a partner at private equity investment platform Cepres, says private credit has performed well in down markets. “When stock markets go down, everyone gets nervous. That impacts the buyout market as well as traditional financing. That’s when the banks pull back.”
Cepres sees a direct correlation between buyout and public markets. In the boom years, buyout pricing tracks stock markets and there’s plenty of financing available. During volatile times, traditional credit sources dry up and private debt steps into the vacuum at better yields. “There’s a counter-correlation with private debt,” says Godfrey, “and more downside protection in a downturn.”
In a recession, other factors favour private credit. Since the last downturn, non-bank lenders have worked assiduously to diversify their own financing sources. No longer relying on commercial paper or short-term lines of credit, they are arranging long-term commitments from both banks and third-party institutions to weather disruptions in the capital markets.
Another benefit is that the assets of leading private credit arrangers are not generally held in mark-to-market vehicles. The underlying loans are illiquid, not freely traded in secondary markets. In a credit downdraft, as we experienced in 2009, these loan values were affected less than more correlated investments.
When problems do arise, recovery rates for mid-sized loans have proved higher than for broadly syndicated ones. That’s because smaller groups of buy and hold shops have aligned incentives. They know it’s better to work with sponsors and borrowers to enhance enterprise value than force a company into liquidation.
Our position in the business cycle may ultimately be answered only in hindsight. As to how investors should respond to an inflection point, Godfrey believes more education is needed. “Investors are still not clear on where private debt fits,” he says. “This has historically restricted deployment of capital that could potentially come into the market.”
He is, however, positive. “There’s plenty of room for private debt. It’s taken a long time, but sophisticated investors are finally putting dollars to work there.”
This column first appeared in the weekly newsletter of Creditflux, a leading global information source for the credit trading and investment market.