Commentary: Private credit – Is now a good time to invest?

As we turn toward the ninth year of economic recovery in 2018, risk-taking appears to be on the rise not only in the equity markets but also in the credit markets. Relative to the prevailing environment, there are a number of potential risks investors should consider with respect to private credit strategies, as well as some of the opportunities that remain.

Strong fundraising cycles tend to result in more team spinoffs and fund managers that might not have invested across multiple economic cycles. Track records for these teams might be limited and/or difficult to assess, and new teams might have limited experience and/or minimal or no prior experience investing together. Additionally, teams might not be able to keep pace with the amount of capital being raised, and investors should pay close attention to the number and skill sets of individuals focused on origination, underwriting and portfolio management.

We have heard anecdotally that some fund managers are relaxing underwriting standards in order to win deal flow, particularly as it relates to providing fund managers with more leeway to a) take on more debt senior to the existing lenders to repay junior debt; b) effectuate mergers and acquisitions; or c) facilitate restricted payments to equity shareholders without lender consent. We are also hearing that some smaller, regional banks are willing to lend at rates much more compelling than a few years ago and, as a corollary to this, refinancing is a key risk.

This requires fund managers to not only be able to structure call protection to capture fees to compensate for the future coupon payments they must now forgo, but to also have a strong, sustainable pipeline of new opportunities to invest in over the life of the fund's investment period.

We would advise limited partners to inquire about whether the fund manager has completed club deals. If so, ask if the manager had its own legal counsel review these deals and on what the counsel focused. A legal review is important, particularly in situations where the fund manager writes a smaller check compared to others in the debt syndicate. It is also important in situations where the manager is part of a unitranche deal that involves an agreement among lenders to which the company is typically not privy. Legal enforcement of how repayments to creditors may flow in the event of a restructuring event has limited precedent in unitranche situations.

As a follow-on point to the discussion about the strong fundraising cycle, we are seeing some direct-lending-focused fund managers creating or adding to their restructuring and turnaround teams. This is interesting given most direct lenders target the top of the capital structure, and it might foreshadow that fund managers are anticipating an increase in defaults that could result in control of the company. One observation we are hearing is that some direct lenders are shifting more than 80% of their current exposure to senior, secured first lien, and away from second lien or unsecured, subordinated positions, which signals the view that we are indeed in the later stages of the credit cycle, and defaults are expected to rise.

Despite the risks, we remain optimistic about private credit, as it is an evolving market that presents myriad opportunities for limited partners.

Direct lending strategies are typically more insulated from larger-market dynamics and continue to offer a return premium.

Return premiums appear to remain achievable but are more bifurcated toward the lower end of the market (e.g., below $40 million of EBITDA) and in the higher end of the market (e.g., above $75 million of EBITDA). This is due to a number of factors, including differentiated sourcing channels where fund managers with strong networks are able to bypass other sources of competition. On the smaller end of the spectrum, we favor fund managers that possess strong underwriting skills and directly originate transactions. This is important because these fund managers appear more protected against losses given they structure terms and covenant provisions that are customized to the specific financial and operating metrics of the business while also providing companies with more flexibility than solutions offered by traditional financial institutions. On the larger-end, execution certainty and complexity appear to be the primary return drivers.

Special situations fund managers with established track records across multiple economic cycles can provide diverse ways to achieve attractive returns relative to their risk profile.

Fund managers that can provide liquidity quickly in situations where pockets of dislocation occur are particularly attractive over the near to medium term.

Dislocations may include market-specific dynamics. For example, the lack of broker-dealer inventory to backstop sell-offs driven by situational events could provide a distressed-for-trading opportunity for fund managers to purchase debt on the secondary market in companies believed to be fundamentally sound but mispriced based on future expectations. These opportunities have not been available for quite some time on a large scale, however, so require patience.

Fund managers that target specific industry dislocations also are well positioned. These fund managers tend to embrace complex situations where competition is relatively less intense but where financial structuring acumen and deep knowledge of the company and sector is required. Fund managers we favor include those that possess the flexibility to invest throughout a company's capital structure and deploy capital opportunistically across economic cycles. Fund managers may focus on rescue financing opportunities or other opportunistic debt investments where they can generate an equity-like return. Investments are typically structured with significant protections in order to minimize the potential for losses, and most investments include coupon payments or preferred equity dividends.

Private credit is an exciting and evolving part of the private market that offers a unique opportunity for limited partners to generate an attractive return while providing downside protection and a growing selection of fund managers from which to choose. While risks are prevalent, there are a number of attractive ways for LPs to allocate capital across the private credit spectrum.

Raelan Lambert is managing director in the Sacramento, Calif., office of Pavilion Alternatives Group LLC. This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.