Unlocking private credit: Looking for yield in times of rising rates and inflation

We recently sat down with Invesco’s Head of Global Private Credit, Scott Baskind, Senior Portfolio Manager and Co-Head of Credit Research, Kevin Egan, and Managing Director, Private Debt, Steve Crino, to discuss opportunities in private credit and where they are finding attractive potential in today’s market climate.

Q: How is the current macro environment shaping opportunities in private credit?

Scott Baskind: The present macro climate has certainly affected how many institutional investors are approaching their credit allocations. Supply-chain disruptions, inflationary pressures, the shift to Fed tightening and the Ukraine invasion all remain top of mind, and this has created a real focus on interest-rate risk exposures, as well as the relative risk/reward opportunities across the broader credit spectrum. We’ve seen this play out in the flows out of long-duration strategies and into shorter-duration and floating rate options. Nonetheless, we still see tremendous appetite for high current income and engagement on how to achieve that goal in today’s environment.

With those considerations in mind, opportunities in senior secured floating rate loans have been of significant interest, particularly in syndicated loans and direct lending. These instruments have the benefit of being senior in the capital structure and secured by the underlying assets of the business, which is particularly attractive in today’s environment. Moreover, given their floating rate nature, interest rate risk is effectively muted. For investors looking for high income with liquidity, syndicated loans have remained attractive on absolute and relative basis with a target return in the 4 to 8% range. For investors who seek higher levels of income and are able to hold more illiquid credit positions, direct lending has been highly sought after and targeting returns in the 8 to 12% range.¹

^{1Source: Invesco as of March 31, 2022, updated quarterly. There is no guarantee that these targets will be achieved.}

Q: What opportunities are you seeing in syndicated loans?

Kevin Egan: Technicals and fundamentals have remained broadly supportive in the syndicated loan segment. The supply and demand has remained in good balance and we have seen resilience in overall market credit spreads. Demand in this asset class remains largely driven by institutional investors who tend to have a longer term horizon stabilizing the overall market dynamic. From the supply side, we continue to see issuance meeting demand intersecting at attractive overall pricing for credit investors.

Defaults—the primary risk in these instruments —have remained extremely low, currently around 0.4% in the US and 0.2% in Europe.² Even with the prospects of slower economic growth, we expect defaults should remain relatively benign. Average debt-to-enterprise value has been declining on deals coming to market, and interest coverage ratios have continued to be favorable, with borrowers generally well positioned to absorb higher interest rates as yields cycle up. That being said, in terms of individual security selection, we have been mindful of issuers that are more sensitive to inflationary pressures, especially in labor costs, such as in the restaurant and retail industries. Moreover, we have paid keen attention to the issuer’s abilities to pass through increased costs to customers to avoid issues around margin compression.

^{2Source: Credit Suisse Credit Strategy Default Statistics, based on trailing 12-month par-weighted default rates. As of March 31, 2022.}

Q: What about direct lending?

Steve Crino: Syndicated loans and direct lending share many similar characteristics. However, there are some key differences in areas such as market accessibility, issuer size, liquidity and return premiums.

Direct lending generally refers to senior secured loans made to middle market companies (typically with enterprise values of $750 million or less) by non-bank creditors, without using a syndicate or intermediary, such as an investment bank. Because of this, direct loans tend to generate attractive return premiums over syndicated loans, through higher origination fees and coupon rates, but it can be a hard market for investors to access. The underwriting process tends to be very complex and time consuming, and deals are typically designed to be held to maturity and not intended to be traded. This means there is fundamentally less liquidity in the segment but also very little volatility, with low correlations to other credit assets.

The market has been well established for years and has grown quite large. One of the main growth drivers has been private equity interest in the middle market. There are more than 200,000 US middle market companies, employing more than 50 million employees. Many of these businesses have capital needs for growth, acquisitions, refinancings, etc. Upwards of 70% to 80% of this financing demand is currently being driven by private equity firms, with close to $600 billion of dry powder waiting to be deployed—more than double from just 10 years ago.

Direct lending has generally maintained a stable pipeline of activity across market cycles, and the present environment is broadly no different. Market forces, such as inflation, rising rates, overall investor uncertainty can and often do translate to volatility in the public markets. In our experience, we often see those events result in reductions in valuations for private markets transactions and can often result in higher spreads and yields for newly originated loans with even more conservative credit protections. Similar to syndicated loans, direct loans are structured as senior secured debt with a claim on the assets of the company; combined with conservatively structured transactions, these considerations may help to significantly mitigate downside while continuing to offer high current income.

In this short video, Head of Private Debt and Senior Portfolio Manager Ron Kantowitz discusses why direct lending continues to look attractive in today’s markets and what to look for in a manager.

Q: Can ESG considerations be integrated into these segments?

Steve Crino: Absolutely. Private credit ESG considerations are fully ingrained into our due diligence and credit underwriting process. With larger companies, this usually takes place in the evaluation phase, as it relates to a business’s disclosures, policies, procedures, governance structures and key measurement metrics. For smaller firms that may not be as sophisticated in terms of resources or as far along in ESG development, it can often be more about engagement and education to help them actively develop their policies, disclosures and other initiatives.

Kevin Egan: Ultimately, we approach ESG risk as a credit risk. A key challenge is that many of the tools available for publicly traded investments aren’t necessarily available for private assets. To help address this, we were one of the first loan managers to develop our own proprietary ESG ratings methodology. Every credit we underwrite has its own overall and individual E, S and G scores, specific to its industry. These ratings are constantly being monitored and refreshed throughout the life of the loan, so that we gain a real understanding of what a company is doing in terms of ESG issues today, as well as how it progresses over time.

Q: What should investors be looking for in private credit manager selection?

Scott Baskind: We believe there are several critical attributes to consider. First is size and scale. Is the manager able to secure a steady supply of deal flow? Does it have the resources to effectively research and underwrite these opportunities? Second is experience. Is there a proven track record through a wide range of market cycles? Third is process. Is there a time-tested, repeatable, transparent investment process in place? What drives it, in terms of bottom-up security selection and top-down macro risk positioning? How does this shape overall strategy risk/reward exposures?

And finally, consider the manager’s organizational structure. Platforms with a specialized private-side orientation can allow for greater access to management and financial information to aid investment decisions, including early looks at new loan transactions. This can offer meaningful information advantages compared to managers that are structured more as extensions of their publicly traded credit teams.

Ask your Invesco representative or visit invesco.com/privatecredit for more information about Invesco Private Credit strategies.

This article has been prepared solely for informational purposes and is not to be construed as investment advice or an offer or a solicitation for the purchase or sale of any financial instrument, property, or investment. It is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. The information contained herein reflects the views of the author(s) at the time the article was prepared and will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing or changes occurring after the date the article was prepared.

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