Navigating the private debt market in 2024
Q&A with Callum Bell, Head of Investec Direct Lending
What are the main challenges for private debt?
Firstly, if we take a macro view, we've seen some extraordinary interest rate rises in the last couple of years, meaning today's private debt market is very different to what we've seen since the global financial crisis.
After more than a decade of low interest rates, we now face substantially different credit conditions.
As floating rate instruments adjust, many investments now have a far higher cost of capital than initially anticipated, which has a direct feed through to the debt capacity of corporates and consequently the private debt market as a whole.
The second challenge is high cost inflation, which is added to the intense pressure businesses are under to generate cash flow.
Legacy portfolios containing deals underwritten before the interest rate rises poses questions around credit performance and looming maturity events.
By contrast, new transactions are better calibrated to the higher interest rate environment, meaning private debt managers are effectively navigating two separate worlds.
So different skill sets are now required from credit managers. One for managing existing portfolio pressures and one for maintaining deployment.
That means deploying dry powder with today's more lender-friendly terms while simultaneously managing the downside risks for for legacy borrowers which disproportionately impacts investor returns.
What are the main opportunities for private debt?
We believe that with challenge and uncertainty always comes opportunity.
First and foremost, a more lender-friendly market environment creates opportunities for credit managers and investors. Higher interest rates mean newer vintage funds are looking at double digit net returns.
They're also benefiting from a more conservative credit underwriting environment, where deals are being structured with tighter documentation and lower leverage.
In addition, the challenges surrounding legacy portfolios are creating opportunities for managers to differentiate themselves against their peers.
Those with robust portfolios who can navigate the challenges will stand out in an increasingly attractive market for investors, which will support their future fundraising. This is good news for investors.
They can see how strategies differ as the cycle progresses and this can support their asset allocation making.
So movements up and down the yield curve may see opportunities for certain asset classes to come back into vogue, which will provide extra choice for LPs.
For example, asset based lending could lower rampant capital costs while subordinated facilities could slot into any overleveraged structures. Read more in our article, Discipline to differentiate: Challenges and opportunities for private debt.
What have been the implications for capital structures?
In 2023, as valuations trended lower, private equity managers were more considered around equity cheques for their new investments. Lower equity cheques mean lower debt packages, with a renewed focus on the cost of capital.
In 2024, we expect more accurate pricing for risk and at better terms, particularly for smaller borrowers who are the most underserved by managers.
In today's deal packages, we're seeing a purer form of debt financing, with the emphasis on the value of covenants and cleaner earning metrics, and with fewer EBITDA adjustments. This helps to give an early and accurate warning sign of distress.
It also offers lenders and borrowers the opportunity to sit around the table earlier when optionality is at its highest. Together, they can then agree on plans that unlock better outcomes for all stakeholders.
In contrast, the 'covenant-loose' cycle, prevalent until 2022, resulted in many businesses falling into distress too quickly. Warnings were given too late and leverage was breached at levels that were too high.
Looking ahead, we expect a market that's more rigorous and differentiated, coveting some of the softer values of lending.
What does a good capital structure look like now?
Until 2022, and before interest rates increased, we saw a sustained period of leverage creep, reaching average levels closer to six times EBITDA in the latter half of 2021.
Too much leverage is a 'cardinal sin' of debt investing, as markets can change rapidly.
We often refer to the sobering expression that debt investors 'earn pennies and lose pounds'. So it makes sense to prioritise capital preservation, a key pillar of our investment decision making here at Investec.
This view helps us to remain focused at the point of underwriting and maintain leverage level discipline, even when markets are on the rise. Discipline is vital, and it's encouraging to see that leverage levels have dialled back over the past 12 months.
In our view, perfectly formed capital structures should be uniquely crafted for a specific business capable of performing in the good times and downside protection in the bad times.
Achieving this requires a holistic approach to assessing the credit, rather than just looking at the numbers. Our fundamental-based approach with low leverage attachment points supports a robust portfolio with minimal losses.
However, it remains to be seen in 2024 whether the market will stay true to these principles or accept lower coverage ratios in the quest for deployment.
