INSIGHTS

On July 31, 2024

Capitalizing on Compelling Private Credit Opportunities in a High Interest Rate Environment

Attractive market conditions for cycle-tested investors

While headlines this year have been dominated by the talk of the revival of banks, the reality is that yields, structures and documentation in private credit have continued to offer what we view as compelling opportunities for a proven, cycle-tested manager to capitalize on in this high interest rate environment.

We believe the ingredients for a return of merger and acquisition (M&A) activity are in place: there is a significant amount of private equity dry powder waiting to be invested, pressure from limited partners to return capital, a deep private credit financing market and the expectation of eventual rate cuts. While we expect some continued choppiness in the market for the remainder of this year due to the U.S. election, geopolitical concerns and the wait for the U.S. Federal Reserve to pivot, pressure has been building to deploy capital and realize investments. We have already seen a pickup in activity this year as leveraged buyout activity grew year over year for the first time since the first quarter 2022.

Private credit has continued to be the financing choice for companies and sponsors with private credit accounting for an 85% share of buyout and M&A activity this year. Even if this elevated level of private credit financing is not sustained, private credit’s value proposition and permanent role are clear, and we look at this as the new era of capital delivery to companies.

Market segmentation matters

Significant amounts of capital have been raised by asset gatherers in private credit, creating an immense pressure to deploy capital in upper middle market and large cap financings where it can be done so in size and scale. Due to this dynamic and competition with the newly reinvigorated banks, we have increasingly seen a convergence in this market segment with the broadly syndicated markets. Terms increasingly look alike with tighter yields, looser documentation, lax covenants and decreased access to information. Furthermore, portfolios focusing on the upper middle market and large cap financings typically look similar and lack differentiation as they are pressured to participate in every jumbo transaction that comes to market, lest they fall behind in their deployment targets.

While larger managers have moved upmarket to replace banks, the core middle market and lower middle market remain generally less competitive where financings are satisfied by one or a small number of lenders and borrowers often rely on a value-added partner to help grow their businesses. Here, lenders often have more influence and control over structure, pricing and a greater ability to build protections and rights into documentation.

Value of incumbency and rise of portability

Incumbency provides a proprietary pipeline of investment opportunities, as the incumbent lender is typically the first call for any additional capital needs. The incumbent lender also has unique insights into the historical performance of the company and capabilities of the management team, and as such can often efficiently re-underwrite the business with speed and conviction.

Today, incumbency may be hardwired into transactions for the highest quality credits, due to the growing use of portability provisions. Portability allows the existing debt package to remain in place through a change of control transaction and leaves the incumbent lender invested in a well-known credit. Portability provisions have increased in prevalence as borrowers refinance or amend their existing debt structures in advance of upcoming maturities but are planning for a short-to-medium term exit.

The importance of staying disciplined

There are many compelling opportunities in private credit today for those who have the experience and know-how of investing through multiple cycles and a track record of staying disciplined. Yet there are also many pitfalls waiting for less experienced and less disciplined managers who may not have the experience of investing through cycles or who may simply be prioritizing gathering and deploying assets.

We expect today’s higher-for-longer rate environment to reveal which managers have been doing the hard work of staying disciplined in underwriting, negotiating stringent documentation and actively monitoring their portfolio, and which managers have not. This is a market environment where manager selection is vital, and we could see a growing dispersion of returns among asset gatherers and true credit investors in private credit.

CRN: 2024-0717-11837 R

Sources: Leveraged Commentary & Data (LCD), PC & MM Q1 2024 Quarterly Stats, as of March 31, 2024.

This commentary is made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Nor is the information intended to be nor should it be construed to be investment advice. Certain information contained herein concerning economic trends and performance may be based on or derived from information provided by independent third-party sources. The author and Crescent believe that the sources from which such information has been obtained are reliable; however, neither can guarantee the accuracy of such information nor have independently verified the accuracy or completeness of such information or the assumptions on which such information is based.