DBRS Morningstar’s Takeaways from ABS East 2021: Trends in Private Credit Are Here to Stay

As part of its takeaways series, DBRS Morningstar is publishing several write-ups about pertinent topics discussed at ABS East 2021, an industry conference for the asset-backed securities (ABS) sector. DBRS Morningstar’s Jerry van Koolbergen joined Nancy Beebe (Capital One), Theodore Koenig (Monroe Capital LLC), and Scott Rosen (Ares Management) as the panelists for Middle Market Lending and the Expanding Role of Private Credit.

Nancy Beebe began by discussing the state of the ABS market. She highlighted the robustness of issuance in both new issuance and refinancing segments, which at the end of Q3 2021 was not only higher than 2020 but also almost $15 billion ahead of 2019. The market has been resilient through the Coronavirus Disease (COVID-19) pandemic, primarily because balance sheets were so healthy leading into the downturn, and lenders and sponsors have collaborated to work out covenants and manage risks during the ongoing pandemic. She also mentioned that middle market fund raising had been very strong in the last five years, primarily in private credit. Collateralized loan obligations (CLOs) had the benefit of very strong investor demand.

Scott Rosen noted how the lower middle market (defined as approximately $35 million to $40 million EBITDA) is a more inefficient segment and requires more tailor-made solutions. However, there has been robust growth in mergers and acquisitions, and a large number of private equity (PE) buyouts and PE-to-PE transactions. Sectors that saw a lot of activity in the pandemic era included healthcare with an emphasis on the behavioral segment, fintech, business-to-business and business-to-consumer, CLOs, and the special-purpose acquisition company market. Rosen highlighted that valuations in the private markets, while high in absolute terms, were relatively reasonable when compared with valuations in the public markets. An important point raised was that private unitranche deals are overtaking broadly syndicated deals. Rosen also discussed the sponsor’s reasons in choosing high yields in the public markets versus private loans, and emphasized that speed and privacy (requiring fewer disclosures) were the primary benefits of private markets.

Jerry van Koolbergen highlighted the perspective of a credit rating agency. He discussed important issues regarding the financial structure of the deals—the use of leverage, covenants, and collateral quality—and mentioned that deal structuring had become more creative over time. He also noted how fund-related credit ratings are becoming more important in order to facilitate syndication among insurance companies. Beebe added to this point by mentioning that as an investor, Capital One would hold investments in various parts of the capital stack from rated to unrated, and the presence of other investors is an important indicator of quality.

The panelists discussed the growth in private capital since 2015, and their thoughts on whether this was just a matter of a search for yield or an investment trend that would continue. Rosen believes that private credit is here to stay and that middle market lenders have taken over some of the role that banks traditionally played. He mentioned that although private credit spreads will likely compress in the future, this industry is healthy because it had avoided exposure to troubled sectors like oil and gas and retailers. Koenig agreed that the private credit trend will continue because, given the long-term liabilities of insurance companies, fixed income investors need newer investment options. He pointed out that we have witnessed the rise of model portfolios with different asset allocation targets. This implies that the large returns from public equities in recent years have led to growth in portfolio sizes and, given asset allocation targets, result in dollar flows to private credit and other asset classes. Private credit has become an important asset class and is no longer just a J-curve mitigant to PE.

The panel discussion then turned to the performance of CLOs. Van Koolbergen highlighted the good performance of CLOs last year, which was much better than expected: Approximately only 3% of the portfolio and 1.5% of issues had downgrades, though idiosyncratic risks certainly remained for many issuers. Beebe raised the point that the average credit quality is B- (B minus) in this space and is designed to have many credit enhancements and a lot of cushion for investors. Van Koolbergen agreed and added that credit ratings of B- (B minus) and below have lower leverage and extra cushion, and that typically investors get more cushion and buffers against downgrades and defaults as they move from syndicated to private deals.

Continuing on the topic of credit ratings, Koenig raised the point that credit rating firms did much better in the pandemic era compared with the Great Recession in 2008–09. During the Great Recession, the credit rating firms proactively rated issues as Selective Default and pushed the hands of asset managers. During the current downturn, however, rating firms have taken a more thoughtful sector-specific analysis to identify winners and losers. Rosen cautioned that the pandemic risks are still ongoing, so there is room for change when trying to name winners and losers, or determining the accuracy of rating actions.

Looking at future trends, Rosen mentioned that PE, insurance companies, and other large investors look at financial markets holistically. He identified new investment areas like music rights and library rights. Van Koolbergen agreed and reiterated the growth of esoteric finance and how rating firms have to be nimble and have statistical tools to rate deals in such new areas. Koenig emphasized that currently the private credit market is focused on asset gathering, but in the long run it is the alpha or value added by asset managers that will identify the winners. Asset managers who provide differentiated and superior risk-adjusted returns will be the winners. Beebe raised the issue of the huge amount of money already raised and waiting to be deployed, and highlighted the much higher leverage (defined as Debt/EBITDA) in leveraged buyouts at 6 times (x) relative to that in the middle market of approximately 3.8x.

The panel also discussed the issue of Libor transition. Koenig highlighted the possibility of Libor-Secured Overnight Financing Rate (SOFR) arbitrage (liabilities being Libor based and assets being SOFR based), and the need for caution until the Libor-to-SOFR transition is complete. Van Koolbergen mentioned that from a rating agency’s perspective, this transition is viewed as an operational risk only. Rosen expressed the view that markets are currently in a price discovery period around the transition and it might be worthwhile waiting for the repricing to be over.

Written by Indrani De, CFA, PRM, Global Head of Investor Strategy

Notes:
All figures are in U.S. dollars unless otherwise noted.

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