Credit spreads are compressing. Loan covenants are loosening. The credit cycle may be nearing a peak. And geopolitical uncertainties are rampant.
If those laments sound familiar, they should. They were raised repeatedly in analyses of the credit and finance markets . . . in 2017.
But one thing is different today, and that is the sheer volume of investment capital crowding into private and alternative finance, so that firms now sit on a huge stockpile of cash and commitments. Markets are increasingly described as frothy: Too much capital chasing too few good opportunities.
Just how frothy? It depends on who you ask and where you look. According to research firm Preqin, “private capital” dry powder reached an estimated $2 trillion in 2018, an increase of $500 billion just since 2016. JPMorgan Chase & Co. pegged the amount of dry powder sitting in “alternative” firm accounts at around $1 trillion, still a considerable increase from earlier estimates.
What analysts and participants all seem to agree on is that fund managers feel pressure from their investors and LPs to put capital to work at a time when finding good deals is getting more difficult. Private credit in the form of leveraged loans has provided so much capital to private equity firms that company valuations are rising. At the same time, underwriting standards are slipping (a point noted in recent FDIC reports that look at bank business lending practices). Borrowers now often have the upper hand in setting terms – creating “covenant light” deals that can make risk managers wince.
Froth, it seems, is everywhere. But not all froth is created equal. Some segments are frothier than others.
As of mid-2018, up to 80% of dry powder was concentrated in private equity and venture capital, leaving about 20% for private credit. A closer look at private credit shows that most of the loan volume involves larger, traditional cash flow deals like leveraged loans supporting private equity deals or middle market direct lending. Not surprisingly, double digit returns that were common a few years ago for direct lending funds that target these segments have all but become extinct. Too much froth.
At the other end of the scale are smaller, niche private credit firms like Old Hill Partners and its asset-based lending strategy. While there may be competition among smaller players as well, it is still possible to find deals that pay greater investment rewards without undue risk. But the underlying deals are smaller – often too small to move the needle at larger firms (which is why Old Hill focuses on what the market perceives as smaller balance (i.e. sub $25mm) lending transactions).
Certain smaller asset-backed loan deals offer attractive returns at manageable risk. One such niche, nonprime consumer loans, can be structured to shield the private debt fund from the higher loan default rates that attend this sector while capturing the upside of higher loan interest rates. What makes this strategy work is expertise in sourcing and underwriting deals. And it helps that these small deals aren’t as crowded. Less froth means more negotiating power in the form of covenants for the private debt manager.
Navigating today’s frothy private capital markets requires a nuanced approach and extra diligence in sourcing and underwriting. But with a careful and thoughtful approach, good deals can still be found. This is evident in the asset-based lending strategy that Old Hill employs. Additionally, as the credit cycle ages, an asset-based lending approach may be less sensitive to the economic cycle and provide investors with a more defensive position in private credit while earning an attractive yield.
It’s like finding a coffee shop with a barista capable of concocting a well-balanced cappuccino: not too strong, not too weak, with just the right amount of froth on top.