NEW YORK, Aug 29 (LPC) - Private credit funds and business development companies (BDCs) are positioning their portfolios to deal with a potential economic downturn, which will be the first real test for a market that has come of age since 2008’s financial crisis.
Downwards pressure on US interest rates, intense competition to deploy capital and a possible economic recession are prompting private debt funds to shift to more defensive investment strategies.
“2018 was the year of asset compression and we’ve had three straight quarters of asset spread widening that benefits us,” said Grier Eliasek, chief operating officer at Prospect Capital on the BDC’s recent earnings call.
“Some people have been predicting it (a downturn) for five years. I guess if you predicted five years ahead of time, you’re right eventually. But eventually the cycle turns and we want to have the strongest fortress to handle that,” Eliasek added.
The need to balance mounting economic risk against generating returns is encouraging many BDCs to move to less risky lower-yielding assets, and take advantage of leverage at the fund level to generate higher returns.
Goldman Sachs BDC saw first-lien assets increase to 74.43% from 65.16% and second-lien assets fall to 18.48% from 20.71% over the second quarter. The BDC’s total debt increased to US$842.8m from US$704.4m in that period.
New Mountain Finance has steadily increased the proportion of its portfolio in first-lien assets to 52.75% and decreased its second-lien assets to 27.35% at the end of the second quarter, up from 39.48% in first-lien and 34.03% in the same period last year. Over that time the firm’s total debt has risen from US$1.2bn to US$1.7bn.
Private credit funds are recruiting co-investors to reduce their costs, while continuing to underwrite large tickets in an increasingly competitive market.
“There has been a steady rise of co-investment strategies that allow managers to increase deal diversity, lower their interest rate risk, achieve higher rates of return and access a wider range of deals that would otherwise exceed the fund’s target ticket size,” said Andrew Stewart, executive director-sales at MUFG Investor Services.
This shift has intensified since the US Federal Reserve cut the benchmark US interest rate in July for the first time in more than a decade. Private debt funds invest in floating rate loans and are moving in time with the policy changes that may reduce loan yields.
Because the vast majority of loans financed by alternative lenders are tied to the Libor benchmark, firms benefit when interest rates go up, but yields are squeezed when interest rates go down.
Yields on first-lien loan and unitranche loans have already been falling as lenders compete to put an abundance of available debt capital to work in US middle market companies. Middle market term loan yields tightened to 7.95% in August, down from 8.85% in July driven by the fall in Libor, according to data from Refinitiv LPC.
Competition between funds was cited as the biggest challenge for returns by 61% of private debt investors in a Preqin report, while 48% said credit spreads, and 47% said credit profiles.
Direct lending strategies that target senior loans remained the most popular destination for investors in the asset class, and 49% of those surveyed said they provide the best opportunities in the market.
Some lenders are optimistic that spreads will widen again as investors push back on aggressively priced and structured deals to cover their own costs and offset lower base rates.
But even if the trend when rates go up is for spreads to tighten, some fear the reverse impact may be slower to take place.
“Historically across cycles when base rates changed, spreads for private loans tended to move in the opposite direction,” said Terry Harris, head of portfolio management, global private finance at Barings. “However, it’s not immediate or a direct correlation, since spreads are also impacted by current supply of capital and demand for private loans. Over the last couple of years as base rates went up spreads gradually tightened.”
Spreads on middle market loans have been falling in the last few years, which is encouraging many funds to use leverage facilities at the fund level to reduce the overall cost of capital, but this can also increase risk.
Investors are increasingly comfortable with using leverage in closed-end private credit funds. Leverage can boost funds’ returns and help them avoid having to book higher-yielding loans.
Private debt funds typically offer two options of levered and unlevered sleeves for investors reluctant to expose themselves to the extra layer of risk.
The Small Business Credit Availability Act was passed last year, which allowed BDCs to assume additional leverage, which many have been using to rotate portfolios into less risky and lower-yielding assets before an expected downturn.
Relying on leverage poses concerns for lenders, however, as this could also amplify losses during a downturn.
“Leverage cuts both ways. It can enhance fund returns, but if you lose money on a deal it can amplify the impact,” Harris said. “So in a fund with leverage, it is critically important to understand the credit risk of the underlying investments.” (Reporting by David Brooke and Leela Parker Deo. Editing by Tessa Walsh and Michelle Sierra.)