Strong Demand Drivers Underpin Private Credit

As institutional investors search for appropriate diversification and return beyond the traditional markets, private credit remains an attractive opportunity. The sector is experiencing strong demand drivers and attractive returns — and it has not been as buffeted by the crosswinds of market volatility and geopolitical risks as have the public markets.

Antares Capital — which manages one of the largest and most diversified portfolios in middle-market private debt — has maintained a selective, disciplined approach through the recent cloudy market environment. Tyler Lindblad, chief investment officer, and Douglas Cannaliato, senior managing director, originations, shared their insights on the prevailing inflationary outlook, the strong fundamentals of private credit and how asset owners should assess the recent modest volatility in this asset class.

Did the Russian invasion of Ukraine exacerbate some of the inflationary pressures that were already occurring?

TYLER LINDBLAD: Yes, inflation was already an issue prior to the Russian invasion of Ukraine. It’s certainly something we have been focused on since last October, which was well ahead of the [Federal Reserve] acknowledging that inflation was, in fact, not transient and that it was more problematic. Given the way that we view the geopolitical situation and its broader impacts on commodities and the food chain, [the invasion] is going to exacerbate that inflationary pressure.

As a private credit manager, we conduct granular analysis of our portfolio companies on an ongoing basis as the macroeconomic picture evolves. In this case, we have determined the level of direct exposure if they do business in Russia, as well as indirect exposure in their usage of commodities and other supply-chain issues. We have also conducted a similar granular analysis of companies in their exposure to inflationary pressures. We define it as high risk if they experience rising costs that can impact margins long term, medium risk if the impacts are temporary and low risk if there’s no impact.

Also, what I would highlight as good news [as we assess the inflation picture] is that consumer demand remains very strong. The U.S. economy continues to grow, and even if there is the risk of modest margin decline [by companies], that’s going to be absorbed by the equity, and it does not pose, from where we sit, any real risk from a debt or principal risk perspective.

What are some of key indicators you’re watching as we look ahead?

LINDBLAD: As interest rates rise and with the Fed now obviously being more hawkish, you’re starting to see that demand could potentially slow. We currently believe that the U.S. economy is still well positioned in 2022 and going into 2023. But clearly the risk of some sort of recession or stagflation has increased. The Fed has a new tightrope that they’re walking on, and [the risk] is going to make their efforts a little bit more difficult. It is certainly something that we’re paying attention to as well.

When rates increase, private credit is floating rate, which provides the benefit of increased interest income. How do you think about this as it relates to your borrowers?

LINDBLAD: Interest rates by historical standards are still very, very low. Even after the projected increases that we see coming, you’re still looking at LIBOR [London Interbank Offered Rate] or SOFR [Secured Overnight Financial Rate], [which are] potentially in the 2.5% to 3% range, which is still very attractive relative to historical standards.

Also, the reality is that the demand drivers [for private credit] continue to be very, very strong. With equity values being very attractive, [private equity] sponsors are supporting their portfolio companies. If you have those handful of situations where the rise in interest rates is causing the company to not perform as well and face potential liquidity issues, the sponsor is going to be there to support it. We certainly saw that during the COVID period, and our expectation would be for more of the same [level of support] going forward.

Given the strong volume and deal activity that you’re seeing, how does that translate into loan pricing? There’s been a bit of volatility as well, so how do you assess that?

DOUGLAS CANNALIATO: Pricing has remained relatively stable overall [even with the slight volatility]. In the syndicated market, there has been a pricing increase of probably about 50 basis points. In the direct market, pricing has been very stable. The direct market already gets a premium over the syndicated market. On the OID, or original issue discount, side, it’s similar. The broadly syndicated loans have seen modest increases to OID where they were used to getting maybe 99 basis points, that moved to 97 and is probably already back to 98. For the direct market, OID remains stable at about 2%.

LINDBLAD: As Doug mentioned, the volatility in the loan market has been very modest relative to some of the other asset classes, including the stock market. That’s due to the secured, conservative nature of the asset class. And as Doug said, the modest decline that was experienced has already mostly recovered.

But the significant dynamic is when there is some of this modest dislocation, it’s actually very positive for [private credit] because it just makes direct credit even more attractive to the sponsor. When you think about the fundamental growth drivers of direct credit, its favorable equity returns that enable significant sponsor capital to be raised via financing. And currently, this disintermediation that’s going on, where we’re moving from the public market to the direct credit market, really enables us to deploy additional dollars. That, coupled with our incumbency advantage, gives us very attractive ways to deploy capital. ■

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