Lending lowdown Podcast

Risk vs. Reward

Episode 7, Season 1

Host CJ Doherty sits down with Fran Beyers, Head of Capital Markets at Cliffwater, to discuss current conditions in the direct lending market as we approach the end of 2022 and a look ahead to 2023. How will the market play out given the uncertain economic backdrop?

Host: CJ Doherty

  • CJ Doherty: Welcome to the Lending Lowdown. I'm CJ Doherty, director of analysis at LSEG LPC. And I'm delighted to be joined by Fran Beyers, Managing Director, Head of capital markets at Cliffwater and an old colleague of ours here at LSEG LPC before she went on to the exciting things at Cliffwater. So welcome Fran, thanks for joining me.

    Fran Beyers: Thank you for having me. It's a pleasure.

    CJ Doherty: Great. So today we're going to look ahead to the direct lending market in 2023. At this time of year, everyone in the market is always trying to gauge what might be in store for next year. Not an easy task given the uncertainty economic environment we face, but we'll do our best today. So to kick it off, Fran, I think we at LPC, recently surveyed the BDC market and ask what lending deal flow could be like in the first half of 2023 compared to the second half of this year. And the results point to activity being flat to up by less than ten per cent. So what's your outlook for deal flow and also pricing in the direct lending market in 2023.

    Fran Beyers: So I think I'm gonna take the pricing question first because it's easier. Um, I can't see spreads moving any higher at this point. I think they're gonna be flat unless the syndicated market opens back up and puts pressure on direct lenders to become more competitive. In which case you could see spreads tightened modestly. CJ, the math just doesn't work for spreads to keep moving higher, especially given where base rates are. But at the same point, I don't necessarily see spreads, tightening dramatically either due to a more uncertain and worsening macro environment. Particularly what economics are projecting is certainly getting worse. And so we also need to see what happens to spreads in the financing market as they are often correlated to new issue pricing as well. Deal flow, much harder to predict because there's a lot of unknowns. I would say year over year. I do believe 2023 is going to be lower than 2022. But I could see a situation where the first half of 23 is modestly higher than what we saw in the second half of this year. I would agree with the survey respondents. On one end, private equity shops have a ton of cash. They've raised $1.5 trillion over the last four years and they certainly want to transact. And that includes sales. We've seen a lot of sale processes getting pushed into the new year given how volatile the conditions have been. So folks are kinda hoping things stabilize and they can sell more in the first half. And I do believe direct lenders are still open for business and they are looking to lean in and capitalize on the current BSL dislocation. But on the flip side, the bid-ask spread between buyers and sellers is widening. Economic growth is slowing. The macro picture is very uncertain and deteriorating, and that never bodes well for MNA deal-making. So overall, too many wildcards to really predict. And I do believe 2023 has the potential to be a very challenging and volatile year.

    CJ Doherty: Okay, So moving on to talk about portfolio company performance. You just mentioned there that there are risks given like economic uncertainty, and then you have inflation, higher interest rate costs, and print margins under pressure for borrowers. How do you see portfolio company performance and credit quality playing out next year?

    Fran Beyers:  So for those of you that may not know it, Cliffwater, we actually have a clipboard or direct lending index that tracks performance in the private credit space. And we just published the results last week. And non accruals, as of 930, we're still near record lows at only 1.26%. So that's well below the historical average of around 2.24%. So what that shows is that middle market borrowers have been navigating inflation, supplying supply chain issues quite well over the last 18 months. Meanwhile, if direct lenders are looking at their portfolio, their continuing to see revenue growth, and there's 100% then margin pressure. I don't think anyone can deny that. But it hasn't been at a level that's causing defaults yet. So let's talk about rising interest rates because that's the biggest issue moving forward. We're not yet seeing any change to pick rates within the index through 930. We're not yet seeing borrowers approach bank groups in mass looking for interest rate relief. With that being said, the numbers we're backwards-looking, the full impact from rising rates certainly has not float entirely through the numbers yet. Math is math. And so we would expect in 2023, you're going to see the non accrual rate move higher. Borrowers are going to start to come back to the bank groups asking for interest burden relief. Direct lenders do feel competent that sponsors are going to support these borrowers. And it helps that direct lenders mostly underwrote defensive credits in high-growth sector. So sectors with high variable cost structures, lower fixed costs. Those type of companies have more levers to pull to whether the macro-environment versus highly capital-intensive businesses. However, those higher margin businesses also have more leverage on their capital structure. Those deals were underwritten in a one-percent base rate environment. So all in all, my thesis is sponsors. They paid record high multiples for these companies. They have a lot of equity capital at risk. So what we're going to see us together, lenders and sponsors are going to have to find solutions to help these borrowers, whether higher rates next year.

    CJ Doherty: Okay, great. And I think the private credit markets that they have grown dramatically in recent years. And our recent survey points to BDCs e.g. not growing at the same pace next year as we've seen in the last two years. So what's your outlook for fundraising and the overall direct lending market next year?

    Fran Beyers: So compare it to the last two years. I'd have to say fundraising is likely to slow down pretty meaningfully in 2023. And there's a few reasons. Let's look at the investor base. So first, looking at the institutional channel, you're seeing a lot of pension funds struggling with the denominator effect. As their traditional portfolios are taking big valuation hits. Many are now over-allocated to alternatives. So that makes it much harder for them to write new checks. In fact, we're already seeing a material pickup in secondaries as some LPs are trying to sell some of their fund holdings to try and bring those allocations back into balance. So that's going to continue. In the last few years, we've seen big allocations coming from institutional investors in Asia, e.g. that ultimately came to a standstill at the end of this year and the fourth-quarter. First, due to growing concerns for the US economy, these foreign investors are observing the dislocation that's going on in the US leveraged loan market, it's giving them pause. And secondly, and most importantly, it's the rate of volatility and FX rates versus the US dollar and other currencies has jumped to unprecedented levels. So it's lowering the returns in Asia, e.g. anywhere 3-5% in their local currency and they didn't budget for that. So there's hope that those investors in Asia begin allocating again in 2023 is FX rates stabilize and move back into balance, but it's going to take a couple of quarters for these folks to get comfortable. Then moving to the wealth channel, CJ, which to your question on BBC's wealth channel has been a big driver of the growth in the perpetually private BDC vehicles. You are definitely seeing inflows slow. Many of these investors, they're becoming a little bit more risk averse. They're also trying to rebalance their portfolios. However, I do believe wealth is a bright spot. It's very under allocated to direct lending today. And so while these flows are slowing, they're still coming in and they're still positive. So we believe that segment of the market is going to be a long-term driver of growth in our space over the next five to ten years, but they're not going to funnel money into loans next year at the same pace that they did the last two years. And then my last point here is, given the rise and rates, you simply have more investment options to choose from, like cash, treasuries. And you're starting to see folks, see bonds is more attractive again. So those areas are probably going to take some share away from private credit in 2023.

    CJ Doherty:  Okay, great. Now Fran, I just want to touch on something that was in the news recently. The Blackstone private credit fund has seen explosive growth since it was introduced nearly two years ago. And it now has over 50 billion in assets. Notably, though, it recently was announced that a hit it's 5% redemption limit in the fourth-quarter. And this was the first time this has occurred. Is this a sign of a change in the broader market?

    Fran Beyers: It's a good question. I would say across the space, inflows are slowing and redemptions are moving higher. But not all of these redemption type vehicles are seeing 5%. Some are seeing less, summer seeing more. And there's a few important points to consider as to why. First and most critical is looking at the underlying investor base of each of these vehicles because investors come with their own unique characteristics and risks. E.g. vehicles, some of these vehicles that may have high concentrations or chunky investor bases are at higher risk of going above 5% and staying there. Should that chunky investor base run into issues and want to get their money out. On the flip side, concentrations can also work in a manager's favor if that investor base is a group of sophisticated institutional investors who typically take a longer-term view of the asset class, they may be less inclined to exit use volatility so it could hurt you or it could help you. Those managers that have a heavy mix of foreign investors, particularly Asia, they're dealing with a lot of margin account or currency swing pressures that can result in higher redemptions. And then the next big point to consider in these vehicles is valuation. If folks do not believe the marks on the underlying assets are moving fast enough or reflecting true value in a private vehicle, those investors could be incentivized to punch out, take that cash, and go by public or traditional securities at a much lower valuation, right? So this is more common in some of the real estate funds and to some degree, some of the private equity tender or interval funds. You're less likely to see this dynamic and private credit because valuations tend to be more current and you have less public alternatives with a comparable yield to substitute but something to consider. Third, is performance. If investors for whatever reason are unhappy with performance over the near to intermediate term, it does raise the likelihood they will exit and reallocate elsewhere. So e.g. if investors are seeing big swings in unrealized markdowns when they thought it was gonna be more stable. Or if you start to see a pickup in non accruals, it could raise the likelihood of investors punching out over the next few quarters. The last point I'd like to make on these vehicles, particularly these perpetually private BDCs there a newer phenomena in the market. It's very tricky to balance having enough liquidity to manage redemptions while also staying deployed to maximize your yield, right? There's a balance there. And so while a lot of these investors in these vehicles believe they have some level of liquidity, up to 5% of NAV each quarter. The managers do have the option to put the gates up and say, I'm not going to fill that 5% order. And so the reason why this is so topical and closely watched is because again, these are newer vehicles. We haven't seen them go through a downturn and it comes down to the manager in terms of how they prepare for these redemptions and the decisions they make as to whether they fill those redemptions or not. Managers that honor the redemption requests are gonna give their investor base more confidence that they do have liquidity. But managers that don't, they consistently put the gates up that can have reverberations on sentiment for everyone in the space managing these redemption vehicles. So it will be interesting to watch you know, longer term.

    CJ Doherty: Okay yes. So plenty to watch going forward. Given we're running out of time. Final question for you. Using your crystal ball, what is the biggest opportunity and the biggest risk for direct lenders in 2023?

    Fran Beyers: I don't have a crystal ball, CJ, maybe a magic eight ball. You can shake it up. But the biggest, in my view, the biggest opportunity next year is for direct lenders to do exactly what they told their investors they were gonna do, outperform and deliver a high single-digit return that they promised investors. This is an all weather asset class. We tried to be liquid loans and other asset classes. So if they can do that next year during a really tough macro-environment. My view is the sky's the limit for private credits growth over the next five to ten years. The media, no offense CJ, the media has been very unkind in the last six months, writing a lot of worrisome headlines about the risks and private credit. Meanwhile, I work with managers across the space. I continue to see a big difference in the quality of deals that direct lenders finance versus what gets done in the syndicated market. I am a big believer in what these direct lenders do and their position in the ecosystem. Know furthermore, going into next year and we're seeing it now, direct lenders are getting a real opportunity to right-sized pricing leverage levels. And the docs within their existing portfolio is because sponsors are coming back to the to-do incrementals. They have no competition that BSL markets been dislocated. And so it's a huge opportunity for direct lenders. Banks will eventually start underwriting again. But until they do, direct lenders are going to lean in and pick up assets at very attractive terms. So as long as private credit manager stay liquid, they stay on top of their credits and their firm and asking sponsors to support these borrowers. I'm hopeful they're going to, whether the macro next year, that's going to speak volumes for the asset class. Now, on the flip side, the biggest risk is of course, number one, some sort of exogenous shock that folks aren't prepared for. We saw something like that during COVID. But equally troubling is a long drawn-out period of slow or negative growth. Amid high-interest rates, high leverage levels. That's simply crushes borrowers. That, That's the fear. But if that happens CJ, it's going to hurt everybody. It's not going to just heard direct lenders. It's going to impact the BSL market. It's going to impact the high-yield bond market. Equities is going to get crushed. And so I still believe that in a downturn, direct lenders are better positioned. They're closer to the cash, they're closer to the information from the borrower. And they have strong relationships with PE shops, which helps significantly. So you always see solutions put in place way faster in the direct lending market than what you see in the BSL and high-yield bond market. And that makes a huge difference we sought during COVID that helped borrowers, whether tougher times. And lastly, the long-term locked up and sticky capital that direct lenders raised. It allows them to sit tight and whether they don't get forced to sell assets. And that makes a huge difference versus what you've seen in the liquid markets.

    CJ Doherty: Okay, Great, so much to keep an eye on next year, so we'll stay tuned for all of that. Thank you so much for sharing your insights with us. And thank you all for tuning in. I invite you to check out our direct lending and BDC analysis at loanconnector.com. Follow us on Twitter at LPC loans. I'm CJ Doherty. Subscribe to the Lending Lowdown on your favorite podcast platform.

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