Article
Managers that offer options in both syndicated and private credit markets may capitalise in volatile markets, says Kevin Lawi, private credit portfolio manager and head of origination for Credit Suisse Asset Management’s Credit Investments Group
November 7, 2022
This article originally appeared in the Private Debt Investor US Report, September 2022.
Credit markets have been volatile since the start of the year. What we saw last year was a borrower-friendly market, pricing was tight, terms were looser and leverage was higher. This year the broadly syndicated market sold off and since then the private credit markets have become more lender friendly. Private credit markets tend to lag the more liquid markets, but we think there are many reasons why private credit can present advantages in both a lender-friendly and a borrower-friendly environment. In 2021, our team was focused on both first lien and junior capital solutions.
We tried to find shorter duration opportunities that we thought had a higher likelihood of repayment in the short term. We knew we were in a borrower-friendly market and we needed to be a little creative to find ways to invest that gave us optionality to redeploy when terms moved. Today, in this market, we feel we can actually do more. Right now, we are focused on three main themes. The first is direct first lien opportunities for recession resistant businesses as terms and pricing have improved with the market volatility. We are seeing a number of unitranche deals with wider pricing in both the US and Europe in the private market given the dislocation in the syndicated market. The second area of focus is opportunities in liquid capital structures where we lend because first lien bank debt is trading down in the low 90s or even high 80s.
These borrowers are being shut out of the syndicated markets and are looking at private capital solutions. The Credit Investments Group is among the largest managers in the non-investment grade liquid markets with about $60 billion of assets under management across 800-plus different borrowers. Our platform allows us to take advantage of these hybrid opportunities by providing illiquid tranches directly to borrowers in the liquid markets where we are an incumbent lender. Lastly, we are looking at the secondary market, where we can typically buy liquid credit a few points down from what you see on the screens given our size.
The main issues that we have been focused on this year are obviously inflation, rising interest rates and valuations. The macroeconomic environment has clearly changed and we think we could be heading into recession, so we are naturally focused on our portfolio and trying to avoid businesses we think will be impacted by a downturn. For us it all comes down to cashflow. We are not enterprise value lenders, and while large sponsor equity cheques are nice to see, we think cashflow is what matters when it comes down to getting your interest and principal back in a downturn.
Our focus on larger borrowers in the upper middle market gives us some comfort in an environment like this too. Bigger businesses are typically more diversified and better able to withstand economic shocks and volatile markets. They also tend to have lower default rates versus smaller companies. I think a real pressure point going forward will be valuations and growth expectations. Credit investing should be a compelling way to deploy capital at attractive returns that mitigates impairments because you are senior to the equity and there is cushion. In the last few years, however, a lot of the increase in leverage multiples may come back to bite folks when exit multiples contract and growth moderates.
Some of these higher leverage and junior capital preferred deals that were carried out in recent years may be unexpectedly taking equity risk without being compensated for it. That is something managers and LPs should be sensitive to, and we are certainly focused on it.
Credit Suisse Asset Management is a leading active fixed-income and currency manager. With highly specialized investment teams, we offer innovative and customized fixed-income solutions.
We have looked at opportunities where a sponsor comes to us and says they want to privately place the most difficult portion of the capital structure, the second lien, but they want to broadly syndicate the first lien via the syndicated market. That has become a typical way of financing these days where the sponsor can achieve certainty of execution by privately placing the junior debt. We earn a premium for providing that certainty.
In the current environment, however, these two tranches can collapse into a unitranche structure. We like these deals because its first-dollar risk and the pricing that we can achieve on unitranche today is better than many second lien deals that priced last year, so it is attractive. If the market normalises, we think some of that unitranche demand will go back to the broadly syndicated markets.
Sponsors like talking to institutions that can price all the pieces of the capital structure. We increasingly hear that sponsors want a one-stop shop for public and private credit, because even in good markets they are constantly comparing the two and have built up inhouse capital markets teams whose sole function is to place the liability portion of the capital structure and disintermediate the banks. They want to talk to lenders that can finance both public and private deals because often the execution strategy can change up until the last moment.
Scale and flexible capital are important. Sourcing is important. And then of course you need strong credit underwriting and discipline. The question of scale and flexible capital comes back to this concept of a one-stop shop, where a credit manager can source a broad variety and types of transactions and be a solutions provider.
Sponsor relationships are important to make sure you see the more attractive deals and can potentially influence outcomes when things may not go as planned. Allocation is a form of alpha in our market, so access to the best deals is a way to outperform. If you don’t have high-quality origination you are stuck fishing in a pool that is lower quality.
Most important is underwriting expertise. The Credit Investments Group has 25-plus credit research analysts that know their sectors inside out. They go deep into various subsectors, whether that is speciality chemicals, restaurants, building products, media, etc. We believe that is unique and gives us a competitive advantage.
We lend to over 800 different portfolio companies and that provides its own source of market intelligence. It’s also been our most fruitful source of origination. Being an incumbent in those capital structures is invaluable. We have been lenders to some of these businesses for more than a decade and followed them through market cycles, from small broadly syndicated deals to larger privately placed deals that could shift again to the syndicated market. That history and track record is very important.
"Bigger businesses are typically more diversified and better able to withstand economic shocks and volatile markets"
With all the dollars and dry powder that has been raised by private equity, growth in the private and syndicated markets should be robust. If you ask sponsors, they like optionality. I think that desire for optionality and flexibility will allow these markets to co-exist and compete in a way that is healthy for all market participants. This idea of convergence between the broadly syndicated and private credit markets has been facilitated by the growth and depth of the private capital markets. It has enabled increasingly larger borrowers to access the private credit markets.
Sponsors like being able to tap either market because it creates competitive tension. We like it because we can participate in both markets and offer a one-stop shop to sponsors. Smart credit managers can take advantage of this dynamic by going where the opportunity lies at any given point in a market cycle. Understanding the technical dynamics and flows across both markets creates opportunity for us. The environment that we are in now really highlights this. We can take more of a long-term view due to the format of our capital base which allows us to take advantage of inefficiencies in the syndicated markets.
We get asked this a lot by LPs because we are in both markets and find value in each. A lot depends on what the LP is looking for and the structure of their liabilities. Prior to joining Credit Investments Group, I worked for a large Canadian pension fund with long-dated liabilities that wanted to trade excess return for illiquidity. We could have a long-dated investment portfolio that was highly private-markets focused. Others may be more tactical in nature and want to be able to move in and out of loans quickly. If you are a certain type of insurance company, you may need to have shorter duration in your thinking. Ultimately, a lot depends on the liquidity needs of the client and their asset liability matching.
I do think the nice thing about private credit is it allows a credit manager to generate attractive returns in a variety of market environments. We believe we can generate excess return in lender friendly markets and borrower friendly markets, as well as rising rate environments and declining rate environments. You get to capture an illiquidity premium but still earn current income and get some measure of liquidity that way. So, it has a lot of merits. A lot of institutions have recognised the role of the asset class in their portfolios.
"Sponsors like talking to institutions that can price all the pieces of the capital structure"
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