Private Debt in a high interest rate environment
The fallout from the Covid 19 pandemic, the ongoing Ukraine crisis and global supply chain issues, have provided some European countries with their highest inflation for four decades.
The UK has seen Europe’s most aggressive increase, with November 2022 inflation soaring to 10.7%.
Since December 2021, the Bank of England (the “BOE”) has raised the base rate several times, with the rate now at 3.5%.
The European Central Bank (the “ECB”) have also raised the European rates to slow increasing inflation, but what impact will this have for Private Debt and more specifically, direct lending and distressed debt.
Growth of Private Debt.
Prior to the 2008 Global Financial Crisis (the “GFC”) global Private Debt assets under management (“AUM”) stood below $200 billion. Over ten years later, Private Debt AUM has surpassed $1 trillion, with some estimating that this will double over the next five years.
Tightened banking regulations has caused bank retrenchment and provided asset managers and investors with an opportunity to fill the void. The Private Debt market offered investors access to a sector previously dominated by the big banks and offered appealing risk adjusted returns.
Low interest rates have been the backdrop for strong Private Debt growth, but will it remain a desirable asset class as rates increase?
As the risk-free rate increases investors into private debt have more options for their income generating strategies. A big factor in the historic success of the asset class.
The multiple macroeconomic issues impacting Europe and the UK governments ‘mini-budget’ has brought increased uncertainty in public markets, evidenced recently by the drop in the major UK and European stock exchanges.
In the UK, investors and traders are dumping gilts to ensure liquidity and ability to meet hedging obligations, reports suggest liquidation of close to £50bn of UK gilts since the mini-budget announcement. The Bank of England has stepped in and bought UK gilts, to ease market pressure, but this has had little impact.
With all this uncertainty we believe Private Debt has key qualities that should ensure investors continue to see strong and stable returns, within highly volatile environment.
- Floating Rates – Private Debt commonly includes a floating rate that is can be benchmarked against global reference rates. As base rates are raised, reference rates increase which benefits investors and offers growth within a rising rate environment.
- Duration and Volatility – Private Debt has relatively low volatility, prices are based on the specific borrowers’ financials and performance rather than market factors. As Private Debt is not publicly traded and offers low duration, prices and valuations remain stable and less sensitive to changes in interest rates, whilst also offering good risk adjusted yields.
How will direct lending deal with an increase in defaulting loans, given its previous strong but untested performance?
Direct Lending in Europe is largely untested in an economic downturn. Some would suggest that the Covid pandemic brought an early examination however in many cases Government aid provided protection allowing many businesses to survive, but as this support is withdrawn will we start to see default levels increase and if so, how will the industry perform? We believe that in the long run direct lending will perform well during the incoming stress test, and here are some of the reasons that support this.
- Covenants & Negotiation – Direct negotiation of the loan terms between the sponsor, borrower, and the lender, allow deals to be structured with robust covenants, which protect the lenders and provide early signs of increased default risk.
- Due Diligence – Intensive due diligence at the start of negotiations allows specialist debt managers and investors to review borrower track records, be discerning about each deals merits and demerits and even looking for sponsors who have been through an economic downturn previously.
- Flexibility & support– private lenders offer a level of flexibility that banks can’t due to experience and knowledge of the market and not being required to follow the robust banking regulation. Instead of pushing to enforcement, they can take a more pragmatic approach, minimising default risk. Where there has been a covenant breach experienced work arounds can secure better returns than bankruptcy proceedings.
- Collateral – Many loans will have security over assets that can be used to repay the loan (known as” Collateral”), the value of which could be well above the nominal amount of the loan itself, leaving headroom for movement in the collateral value. In the worst-case scenario, the lender may choose to enforce and sell the collateral, using the proceeds to repay the loan, in part or in full reducing any potential loss.
An increase in defaults may present increased opportunities for distressed debt investors, given the dry powder in the space, is this a positive?
The Covid pandemic brought belief of increased opportunity for distressed debt managers, however, Government safeguards meant that the volume of defaults didn’t materialise. During 2020 and 2021, fundraising for distressed debt strategies was at an all-time high, but that capital has been largely undeployed, leaving substantial dry powder in the market.
With the increase in interest rates and energy prices across Europe and the UK, we can foresee a substantial upsurge in mortgage, loan, and credit card defaults, over the new few months.
Banks may face the worst-case scenario and look to sell unperforming assets to debt managers, by repacking non-performing mortgages and loans into larger portfolios, with heavy discounted prices, to enable efficient sales and cut their losses before the full impact of the downturn is realised.
Is investor money moving from direct lending to distressed debt strategies, or should it be?
In 2021, Direct Lending accounted for around 40% of Private Debt AUM and 20% for Distressed Debt, with several other debt strategies making up the remainder.
A recent global private debt study, noted that 56% and 43% of investors, respectively, will target Direct Lending and Distressed Debt strategies over the next 24 months.
Whilst this does not provide evidence that investors are moving away from Direct Lending towards Distressed Debt, it does show that these are the two Private Debt sub-sectors that are a key focus for investors.
History shows us that Distressed Debt is a popular strategy at the trough of the economic cycle, and after the GFC, there were a few years between market dislocation and distressed debt opportunities.
Over the next 12-18 months, we will see increased distressed debt opportunities and increased fundraising for openings that will rise after the recession. Its yet to be seen if there will be a shift between investment in direct lending and distressed debt but judging from the 2020/2021 distressed debt fundraising, it’s probable that there will be a further abundance of distressed debt dry powder for the next few years.[SM1]
Direct lending and distressed debt strategies are not mutually exclusive of one another, many investors will enter private debt through a direct lending strategy and may look to extend their private debt allocations, by investing in mezzanine, special situation, or distressed debt portfolios. We expect an increase in distressed debt investment but not necessarily expect this to be at the detriment of direct lending.
[SM1]I would add that these strategies are not mutually exclusive. Many investors enter private debt through direct lending and then look to extend their allocation by adding strategies such as mezzanine, special situations or distressed. Given the anticipated influx of opportunities we anticipate allocations to distressed to increase but that is not necessarily to the detriment of direct lending.
Our highly experienced Private Debt and Capital Markets team across the UK, Jersey and Luxembourg have extensive expertise working on a wide range of debt structures.
This enables us to provide the highest level of service to our clients, whether you are a first-time fund raiser or an established fund manager who is looking to improve the service quality you and your investors receive.