Commentary: Senior debt — the overshadowed opportunity now emerging in private credit

During extended periods of low interest rates, it's easy to overlook the role of private debt as the catalyst driving the broader alternatives asset class.

Private debt fuels new investments across private equity and enables the exit activity and recapitalizations that crystalize value creation. Moreover, the liquidity that's channeled into the M&A market also translates into the returns and distributions that typically stimulate new fundraising activity for institutional investors. Most observers, however, overlook the critical role of private debt until a disruption triggers a domino effect felt across the broader private capital ecosystem.

This was what happened in 2022, and this year's trends will naturally give institutional investors pause, particularly as credit quality across the institutional leveraged loan universe deteriorates and as the broadly syndicated loan market remains in hibernation. The volatility across the bond markets is overshadowing a distinct opportunity that now appears to be taking form at the very top of the capital structure, in senior debt, where lenders who cater to private equity's middle market may be uniquely positioned to benefit from the disruption.

Market volatility has disrupted the syndicated loan markets, which are contending with decreased collateralized loan obligation issuance and outflows from retail mutual funds. As a result, commercial banks continue to hold previously underwritten loans and have shifted their focus to placing these hung deals, or commitments banks had anticipated syndicating to other lenders, rather than pursuing new underwriting activity.

As motivated sellers, commercial banks are being forced to absorb meaningful discounts — between 85 to 95 cents on the dollar — to place these deals. As original issue discounts, or OIDs, are priced wider and deeper, the impact on the broader market is that new issue yields are climbing significantly.

Meanwhile, with bank lending and broadly syndicated loan activity on hold, private direct lenders have become one of the primary remaining sources of financing to support sponsor-led leveraged buyout and portfolio company M&A activity.

Within private debt, the middle market has historically offered attractive yields, but, generally speaking, with lower leverage and more robust documentation. In the current environment, however, yields are becoming amplified, while leverage is moderating even further and investor protections become even tighter.

This is just a snapshot, but a broad survey of first lien senior-secured loans by Audax Private Debt last year showed the average spread stood at 5.2% and the average OID was 2.3%.

In the fourth quarter, prospective credits that made it into an active review had an average spread of 6.0% and average OID of 3.6%, translating to an all-in yield of 9.6%, which is historically high for senior-secured middle-market credits.

Moreover, experienced investors will recall that, consistent with prior dislocations, lenders typically become more selective during periods of uncertainty. Generally, only the highest quality deals clear the market, but at leverage multiples a full turn or more below peak environments.

Again, this speaks to the shifting supply-and-demand dynamics and underscores why periods of economic volatility generally correlate to outperformance more broadly across the private debt asset class. According to PitchBook's private debt benchmarks, the two best years for the asset class, based on median internal rates of return, occurred in 2002 and 2009, years that investors will generally associate with the tail end of the first dotcom crash and in the teeth of the global financial crisis.

Other factors are also influencing this asset class.

In the current environment, both banks and private lenders are taking a prudent approach to underwriting and retaining risk. Banks coping with hung deals are less willing to backstop new syndications, and with the capital markets on hold, private lenders have stepped in to fill the gap. The caveat: Concerns over concentration risk and a slower repayment environment are prompting many direct lenders to decrease hold sizes, or the amount of financing they'll commit to a specific credit, and turn to larger lender consortiums for club transactions (deals involving two or more lenders).

Those who remain active are thus able to initiate new relationships across the borrower universe. And it is likely that club-lending opportunities should only rise as fears of a recession and ongoing interest rate volatility influence risk tolerance even for the highest quality credits.

Other considerations are also contributing to a senior debt tailwind. While the consumer price index inflation reading was off of its 9% June peak at the close of the year, 7% inflation remains historically high and keeps the possibility of additional rate hikes in play to drive inflation down to the Fed's 2% target.

The upshot is that higher rates amplify income generation for floating-rate private debt strategies, reflecting one of the more acute countercyclical characteristics of the loan asset class.

At the same time, manager selection becomes more critical for allocators as underwriting capabilities of managers come into focus. Still, middle-market first-lien loans generally offer greater downside protection relative to both broadly syndicated loans and high-yield bonds.

Traditional first-lien, senior-secured loans in the middle market provide the highest degree of structural protection. These loans rank first in priority for interest payments and principal repayments and are typically secured by substantially all available collateral and equity pledges of the borrower. In a worst-case scenario, senior-secured lenders will have first claim on the value in the case of an out-of-court restructuring or bankruptcy.

Moreover, at the very onset of performance or liquidity challenges, protections and covenants within the senior debt holders' credit documents allow for earlier corrective actions. Consequently, senior debt has demonstrated lower historical default rates and higher historical recovery rates relative to securities lower in the capital structure.

Private debt makes the middle-market private capital arena a dynamic and attractive destination for investors, particularly investors accessing an essential component of the U.S. economy that represents fully one-third of the total U.S. private-sector gross domestic product, according to the Small Business Investor Alliance.

Private debt can be an attractive alternative over longer-term time horizons. In the more immediate term, however, the shifting supply-demand picture and structural protections available through senior debt can provide a ballast for institutions seeking to manage the volatility in other areas of the market.

And while it may go against the conventional wisdom, the recent fallout from the failure of Silicon Valley Bank and the recent takeover of Credit Suisse underscores the opportunity set available to private debt managers positioned to deploy capital and establish new sponsor relationships in the process.

Dinko Angelov and Sean O'Keefe are managing directors at New York-based Audax Private Debt. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.