TBY takes an in-depth look at the private debt market, analyzing current positions in the credit cycle.
Global credit markets gave another strong performance in 2017.
Despite rising rates, returns across different markets remained very positive overall. However, the major question haunting private debt investors remains the same: where are we in the credit cycle?
One could easily argue that in the US and Europe credit markets are in later stages than Asia, Africa, or Latin America, but this does not mean the downturn phase is imminent in the next six-10 months.
Each downturn in the last 30 years was associated with either a federal institution that tightened policy too much, a bursting market bubble, or both.
Each of these credit cycle downturns was closely accompanied by an economic downturn during which default rates rose sharply.
Understandably, the unwinding of quantitative easing, a late-cycle economy, stretched valuations, rising rates, and a significant amount of dry powder sitting on the sidelines may all be seen as warnings of a downturn. Although these factors are not necessarily the only catalysts that could trigger the next credit cycle downturn, today we are witnessing a slightly different scenario.
The US Federal Reserve System (the Fed) has begun to normalize interest rates and is expected to do so gradually, as inflation has remained below the Fed’s official target. Same goes for the European Central Bank, which has chosen a significantly gradualist approach to diminishing QE. Aside from the lack of aggressive tightening policies, other major catalysts for an expected end of credit cycle are yet to fully materialize.
These include weakening earnings, elevated levels of M&A, highly leveraged LBO transactions, tightening lending standards, and over-levered balance sheets.
Turning to the private debt industry, the European scenario, home to 24% of private debt fund managers, is advancing from a distressed to a performing stage, with pension funds representing the major source of capital.
Despite being relatively new to the asset class, pension funds are looked at on a relative-value basis. Holding capital comes at a cost for this type of institutional investor, and rather than deploying it on buy-outs for two to three years to then look for somewhere else, they buy into the relatively high returns, relatively low volatility, constant cash-flow guarantees logic of the private debt industry.
This leads back to one of the major benefits of this asset class, namely the fact that it has little correlation to the political risks affecting public markets, equity, or bonds.
In the US, middle-market growth has been consistent, and there is definitely a feeling of being overcrowded, especially among players with a longer history in the industry.
With 66% of all private debt fund managers actively navigating this region, it comes as no surprise the US scenario is the first one to undergo some structural change.
While private debt funds and private equity style funds still dominate the supply market, the industry is witnessing a bigger role of hedge funds. This is particularly true with regards to the direct lending segment, with USD85 billion being allocated in private debt investments and USD77 billion eyed as the estimated target to raise.
Leading private equity buyout firms have also expanded their product offering to include private debt funds, with KKR, Blackstone, and Apollo managing more than USD250 billion in debt and credit assets.
On the other side, institutional investors, led by both public and private sector pension funds, remain the most active, with direct lending being seen as the most attractive strategy by 62% of investors.
However, the relatively positive outlook should not inspire an excessively bullish attitude for investors. After all, both the US and European markets are in the last phase of the credit cycle: credit spreads are tightening, and there is a growing presence of a “hit-and-run” tactics brought by new players, with more experienced managers settling for lower rates for better assets.
Last but not least, deregulation in the banking industry will likely reintroduce traditional lending actors.
This article is the second in our series on private debt. To read the first article click here.
