“I went down to the crossroad, fell down on my knees.” -Robert Johnson (blues musician), from the song Cross Road Blues
Most readers are probably more familiar with the speedier version of Crossroads, as it was the third biggest hit for the band, Cream (behind Sunshine of Your Love and White Room), reaching 28th on the Billboard Hot 100 back in 1969. It’s also been a staple of Eric Clapton’s post-Cream live performances and even the title of his 1988 boxed set. But, as with many classic rock hits, it’s rooted in the Delta Blues. As legend has it, “Crossroads” refers to “the place where [Johnson] supposedly sold his soul to the devil in exchange for his musical talents.”
Keeping with our topic of higher rates and inflation, today we’ll look at additional Alts strategies to understand the impact of the current environment on the ground floor. Since we just covered Private Equity in Part 2, it naturally makes sense to move on to PE’s oft-complementary companion – i.e., private credit. Here we go!
The crossroads: private equity meets private credit
As alluded to above (and as a refresher), private equity and private credit often meet, as a significant amount of the private-credit space focuses on direct lending to private-equity-sponsor transactions. The ongoing high levels of cash yet to be called or deployed (aka “dry powder”) by PE sponsors is very supportive of direct lending, as many deals will require this sort of credit solution. At the same time, we know that private equity companies have been affected by the higher rate / inflationary environment, so the bigger question is whether or not deals can still get done to allow for the deployment of said dry powder.
I believe the answer to that question is “yes,” but there is greater selectivity of deals than in the recent past. As I heard one manager team remark on a conference call, “the deals that are getting done are the deals that can get done.” Meaning that – in this environment – there is heightened scrutiny on the companies involved in transactions. There needs to be greater recession resilience, cash flow (level and dependability to be able to service debt), and/or value-creation potential than before. Otherwise, the math for underwriting deals simply doesn’t work. What PE and private credit investors are attempting to arrive at is creating a win-win scenario at the crossroads (sort of like Robert Johson and the devil – but hopefully more virtuous in nature).
Go big or go home?
What qualifies as a “best company” is subjective. However, based on what we’ve learned about private equity thus far, we can hypothesize that the description includes well-established industry leaders with significant cash flow and manageable debt – which implies these are also among the larger businesses in private markets. Thus, larger direct lenders who can do bigger deals may benefit, which aligns with some feedback from managers.
At the same time – on the lower end of the spectrum (aka “the lower middle market”) – I believe you can apply the same line of thinking. The difference is that those smaller companies may not get the attention of large private equity or private credit players like the upper middle market. Instead, providing businesses with money and resources to grow in ways they otherwise couldn’t (“growth debt”) can be attractive for lenders that understand this space. Thus, I think the private credit team, specific strategy, and underwriting process will ultimately trump general statements like “bigger is better.” Find good managers, and get good results.
With change comes opportunity
Private credit investments – especially in direct lending – often involve floating-rate, senior-secured loans (“floating rate” means the loan interest can move along with market interest rates, and “senior secured” means getting paid before other creditors). Since interest rates are higher, loans now have commensurately higher interest payments associated with them. For instance, strategies that paid a 7% yield at the start of 2022 may now yield closer to 9%. Thus, generating high single-digit income streams in these markets is pretty typical from what I’m seeing. Of course, a higher interest rate is nice, but it’s worthless if the loan defaults, so the “senior-secured” part can be one way of helping to mitigate downside risk. It’s good to be first in line to be repaid if things go awry. Also, in at least one strategy I’ve been monitoring, newer deals are structured with floating rates, whereas fixed-rate loans were typically the previous norm.
When loans are underwritten, many parameters are agreed upon ahead of time, known as covenants. Those agreements could include the ability for the lender to take actions (like restructuring the loan, raising the interest rate, taking ownership of assets, etc.) if a covenant is “tripped” (breached). For example, if debt ratios exceed certain thresholds, it could ultimately be favorable for lenders (credit investors) but not good for the owners (equity investors). There’s a balance and art to working through those situations because it’s generally in everyone’s best interest that a given business continues to do well, service its debt, and repay its loans. At the same time, private credit investors could reap greater returns than private equity investors because more cash flow has to be utilized for servicing debt. Higher debt service means less profitability and a lower equity valuation.
Favorable conditions
If you’ve owned public bonds this year, you may have noticed they’ve decreased in value. That’s because interest rates have gone up. If newer bonds pay a higher interest rate, then older bonds with lower rates of interest are (all else being equal) less attractive and, therefore, less valuable than they were. BUT, if you hold a bond to maturity, and it doesn’t default (so you get fully repaid), then the price decline is just a temporary “paper loss.” While it’s reflected as having a lower value in your investment account at the present moment, it will ultimately provide the total return expected (e.g., “yield-to-maturity” or “yield-to-worst”) at the time of purchase. The bond value is marked to market based on how the environment has changed. An investor could buy a bond like that at a discount and enjoy the reversal of that temporary markdown as the bond approaches maturity.
A similar phenomenon has occurred in private credit. Even though the high, floating interest rates have absorbed much of the impact of interest-rate hikes, older loans have been marked down in value to reflect the evolving environment. Many private-credit funds have a positive total return for 2022, but it consists of two underlying components: a positive attribution from the interest collected (aka “yield) and a negative attribution from a decline in the value of older loans in the portfolio. Assuming low default levels, investors can buy into private-credit portfolios at a discount to take advantage of loans recovering their full value as they approach repayment (maturity).
We may now be at a crossroads where the upward pressure on several inflation measures and general interest rates is easing. Thus, it could be an opportune time to invest in private credit if one believes most of the mark-to-market discount of this cycle is already baked into the current pricing. While private credit almost always involves sacrificing daily liquidity, many modern structures are pretty investor-friendly, and we certainly don’t need to sell our souls to reap the benefits.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
