Join CJ Doherty, Director of Market Analysis at Refinitiv LPC and Ioana Barza, Head of Market Analysis at Refinitiv LPC for a discussion of current trends in private credit, honing in on opportunities and challenges facing BDCs.
Ioana Barza: Welcome to the Lending Lowdown. I'm Ioana Barza, the head of market analysis and I'm joined by CJ Doherty, director of analysis. We're excited to host our first podcast together. And for this, we decided to delve into a look at private debt and BDCs. Thank you everybody again for tuning in. Now the secondary market has rebounded a bit, but we saw a lot of volatility in the broader leveraged market. Loan returns fell to two-year low as bids dropped and the primary market really stalled. Now CJ, what about the direct lending space?
CJ Doherty: Well, initially, there was the usual seasonally slower start to the year, then the broader market volatility resulting from high inflation and expected rate hikes by the Fed led to a valuation reset in the public equity markets. And this has contributed to lower M&A transaction volume year to date. But despite this, the direct lending market has been open and slower to reset to changes in public market conditions. Add-on acquisition financing appear to have been pretty robust this quarter and picked up from levels seen in the first quarter, plus the dislocation in public markets has fueled interest in take private transactions.
IB: And, you know, direct lenders have a sizable amount of money to put the work. We have to mention that fundraising at times has been at a record level. It's been really successful. And so we continue to see these large jumbo unitranches.
CJ: Yes, absolutely. Private equity firms have certainly been able to tap direct lender liquidity for larger borrowers. Recent mega unitranche deals include the likes of the $4.5 billion financing for Information Resources and the $3.7 billion Kaseya deal. Also, a $2.85 billion unitranche backing the purchase of ManTech International. In addition, there has been several deals in the region of $1 billion or more, including the likes of CPI International, Tivity Health and then there was the Risk Strategies upsizing. And so direct lenders are taking share from the broadly syndicated market.
IB: And CJ, just like the broadly syndicated market, they are now also not as insulated anymore from these market gyrations. We have started to see that filter through to the private debt side.
CJ: Yes, exactly, and it has resulted in a period of price discovery as buyers and sellers in the private markets have sought to come to agreement in these choppier market conditions.
IB: And that also means a lot higher loan pricing for the borrowers.
CJ: On the pricing side, direct lending deals were relatively stable in the first quarter. And this was in contrast to the widening seen in the broadly syndicated market. Some of this was due to a portion of first-quarter deals having been signed up in late 2021, at which time the market conditions were really buoyant. Plus, again, direct lenders have large amounts of money to put to work and this has arguably added some stability. But yes as you note, recently there has been some signs of pricing starting to widen this quarter. Nothing huge but the pendulum starting to swing towards relatively more lender friendly terms like price ticking higher or less leverage or getting a better covenant or something documentation related.
IB: Issuers definitely were seeing that they have to pay more. You know, also rates are going up and we have to talk about the elephant in the room, which is inflation. But first, how are BDCs affected by inflation?
CJ: Well, on a positive note, BDCs look to benefit from the rising rate cycle with higher rates set to filter through to interest income and boost BDC earnings. The fact that BDC portfolios are mainly floating rate combined with the shift last year on the financing side to fixed rate unsecured debt provides them with a supportive earnings backdrop. And BDCs, their position to benefit as Libor and Sofr base rates have moved above the floors, which are typically around the 1% mark, though the gains are expected to materialize in the second half of the year as borrowers reset their borrowing benchmark at the end of this quarter.
IB: Yeah, so higher rates are good for BDCs, they’re good if you're an investor. But for these portfolio companies, these higher rates mean rising cost of capital. So far, what are you seeing as an impact on the portfolio companies?
CJ: We are in the early stages of interest rate hikes. Interest coverage ratios at the moment are generally comfortable with the likes of Ares Capital Corp reporting their interest coverage is at nearly three times. And for Goldman Sachs BDC, it was around two and half times in the most recent quarter, and that was unchanged from the prior quarter. So, I think the magnitude of rate increases will ultimately be a factor in the extent to which we see interest costs, pressuring borrowers.
IB: So, it's a little early to tell, right, we're kind of saying that, and that is just one factor because there are a lot more very immediate concerns.
CJ: Performance of portfolio companies has been strong. But BDC managers are closely monitoring their portfolio companies as the operating environment has changed significantly this year. Margins have been trending down. Input costs and labor costs have moved sharply upward, and so challenges lie ahead for a specific companies and sectors. The feedback in the most recent earnings calls was generally it's sectors like software, healthcare, insurance, and financial services had performed relatively well, aided by customer demand and robust sales.
IB: And if we add to those sectors, business services, all these sectors together make up about two-thirds of BDC portfolios.
CJ: Yes, they certainly do. And even going in the opposite direction, BDCs have shifted away from cyclicals in the last few years. So, I would say, still companies across a wide range of sectors are experiencing cost pressures and its companies with low margins, limited pricing power and higher commodity prices that looks set to face the most challenges.
IB: And yet CJ, I think you've seen the credit metrics look pretty good to date.
CJ: Yes Ioana, non-accruals remained low at just below 1.5% and managers also note that loan to value ratios remain low on a historical basis. That said, if economic growth does slow down, we may see credit quality weaken. And I think the general expectation is that credit losses will rise over the next couple of years as inflation and rate hikes have an impact.
IB: But so far, if we think about it as an investor, returns have been pretty attractive, for the public BDCs and how do they rank against other asset classes, especially since we have seen all this volatility.
CJ: Yes, BDCs have outperformed the equity markets. They are down around 5% year-to-date and that's compared to a 12% drop for the S&P 500. And I think this BDC performance has arguably been helped by their floating-rate assets and their ability to benefit in a rising rate environment.
IB: Well, and as we start to think about wrapping up, to that end, BDC assets under management have grown. There are over $230 billion through the first quarter and that's a 60% year over year growth.
CJ: Yes, and you know Ioana the bulk of that growth in assets came from perpetual-life BDCs. Though few in number, their total AUM has climbed to nearly $55 billion. The Blackstone Private Credit Fund for example, alone has grown its investable assets to $40 billion since its inception last year. And more recently, others have joined in. Other perpetual life funds that have come on stream include offerings from Owl Rock, Apollo, HPS and Stellus Capital, and there are more on the way.
IB: So stay tuned. And for our private debt and BDC research, visit us @loanconnector.com. I'm Ioana Barza and here with CJ Doherty. CJ, thank you so much for doing this. And we want to thank all of you for listening to our first episode. Subscribe to the Lending Lowdown on your favorite podcast platform.