INSIGHTS

On March 03, 2025

AAM Viewpoints — Cycle-Tested Values Key to Capturing Today’s Attractive Private Credit Opportunities

Key takeaways

• Secular trends and expectations of a market-friendly U.S. administration have created sanguine conditions for private credit investment.
• We believe a higher-for-longer rate environment could result in rising credit stress across portfolios, underscoring the importance of manager selection.
• Private credit is poised to capture potential opportunities from strengthening U.S. middle market companies and increased mergers-and-acquisitions (M&A) activity.
  

Private credit is likely well-positioned following the U.S. election

The private credit market remains highly attractive today, as its value proposition to both borrowers and investors remains clear and robust, in our view. Capital formation continues to shift on a secular basis to private credit as borrowers value the certainty of execution and ease of use that relationship lenders typically provide. Furthermore, investors continue to value the attractive yields, high current income and better lender protections in more conservative capital structures that can often be found in private credit.

The asset class is likely poised to benefit from expectations of continued U.S. economic strength, lower taxes, market-friendly regulations and growth-oriented policies from a second Donald Trump presidency. These economic tailwinds — when combined with the significant amount of dry powder on the sidelines, aging private equity portfolios and a regulatory environment more conducive to dealmaking — are expected to create the conditions necessary for an attractive M&A environment going forward.

At the same time, protectionist trade policies and immigration reform in an already-tight labor market could put upward pressure on inflation, likely resulting in a higher-for-longer rate environment. We view a higher rate environment as a positive for fundamental credit. President Trump’s proposed economic policies are centered around driving economic growth in a more benign operating environment, which we expect to drive top-line growth across U.S. middle market companies.

It is important to remember that a higher rate environment can have a burdensome effect and pressure cash flows for borrowers, resulting in increased defaults and non-accruals. This potential for prolonged credit stress reinforces the importance of manager selection and the need for disciplined credit underwriting with a focus on capital preservation, strong free cash flow generation and robust debt service coverage. The growing dispersion of performance and returns across managers is expected to accelerate as rates stay elevated.

Increasing importance, difficulty in evaluating private credit portfolios

Assessing the performance of private credit managers and their portfolios can be challenging. Most private credit managers have never invested through a cycle. This makes it difficult to underwrite how their investment returns, default rates and recovery rates would look through a recession or a prolonged period of elevated interest rates. Further compounding the issue is that default rates today may not reflect true underlying performance, as credit agreements can be amended to allow for payment-in-kind (PIK) interest or provide for a maturity extension before any default may occur.

Deteriorating underlying portfolio company performance can explain the increasing prevalence of PIK amendments and the growing presence of PIK interest income in private credit portfolios. For example, PIK interest represents on average 10.5% of investment income (and as high as 18.3% of investment income) for the largest publicly traded business development companies (BDCs)* today, up over 150 basis points from 8.9% just one year ago.

We believe rising defaults and non-accruals across private credit manager portfolios will also test the strength and quality of the underlying credit agreements that provide contractual rights and protections to the lender. Weak credit agreements lacking fundamental protections will expose investors to the possibility of liability management exercises, in which collateral and its associated value can be taken from the lender. Investors were stunned when one of the first sponsor-funded liability management exercises of a private credit-backed company occurred during a highly public faceoff between direct lenders and a financial sponsor over a private upper middle market annual recurring revenue (ARR) loan in 2024.

Outlook for opportunities in private credit

In this extraordinary period of market transition, private credit has the potential to capture the opportunity arising from the economic strength in U.S. middle market companies and a resurgence in M&A activity, providing investors with opportunities for strong relative value and risk-adjusted returns.

We believe a higher-for-longer rate environment should result in rising credit stress across portfolios. Consequently, manager selection will be key as cycle-tested managers with robust origination capabilities, disciplined credit underwriting and hands-on portfolio management expertise will, in our view, have a higher likelihood of generating strong returns with reduced risk.

CRN: 2025-0203-12287 R

* Ten largest publicly traded BDCs by market capitalization as of December 16, 2024, excluding 2024 IPOs: ARCC, BXSL, FSK, GBDC, GSBD, MFIC, NMFC, OBDC, PSEC and TSLX.

Crescent makes this document available for informational 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.