Amid an influx of new lenders, finding pockets of quality
Banks and life insurance companies dominated private credit until regulations born of the global financial crisis (GFC) led them to dramatically pull back. Increasingly, fund managers have stepped into this void, often leading to more competition, lower underwriting standards and the same late-cycle behavior seen in the public credit markets. Against this backdrop, success will require well-resourced specialist managers with unique sourcing capabilities, prudent underwriting and disciplined structuring skills. Lenders taking shortcuts may provide us with attractive opportunities (particularly in the next downturn) in distressed debt and special situations.
LATE-CYCLE BEHAVIOR IN CORPORATE CREDIT
Leverage in the public—and large parts of the private—corporate debt market has increased globally, in many cases exceeding, as a percentage of GDP, pre-GFC levels, and issuance has hit a record. While low interest rates have made this debt burden manageable for now, many investors have deep concerns regarding deteriorating creditor protections—overly issuer-friendly (“covenant-lite”) loans, cash flow adjustments masking leverage, and generally loose underwriting standards (EXHIBIT 1). While default rates at publication time remain well below historical averages, the long-in-the-tooth credit cycle and rising rates increase the potential for market stress and a pickup in default rates, while poor credit underwriting and lack of financial covenants may lead to lower rates of recovery in the event of defaults.
Weaker protections: “Covenant lite” as a percentage of new issuance has grown dramatically
EXHIBIT 1: COVENANT-LITE BOND ISSUANCE AS A PERCENTAGE OF GLOBAL CREDIT MARKETS
Source: J.P. Morgan Asset Management; data as of November 30, 2018.
FINDING POCKETS OF OPPORTUNITY
Parts of the corporate credit market appear stretched, and this requires a cautious approach. Still, not all areas of private debt are overheating. For instance, the U.S. consumer remains in a strong position (EXHIBIT 2). Residential mortgages and consumer finance take advantage of this and face less fierce competition than in the corporate space. In commercial real estate lending, we see less pressure on leverage, underwriting standards and loan covenants. And some of our investors in corporate lending have a generally positive outlook, structuring positions and transactions for the late cycle. Aware defaults could potentially pick up, those teams often prefer deals paying us back in one to three years; which are secured by a liquid asset or those where loan holders or borrowers have few options. Those teams are seeking the greatest margin of safety by lending at the top of the capital structure, continuing to write our own covenants, avoiding what is popular and working even harder to find and structure quality deals.
While recognizing that we are late in the cycle in many developed economies, we believe attractive opportunities still exist. Examples include:
- Real estate mezzanine debt: We expect to continue to originate mezzanine debt on high quality, primarily stabilized core assets in major markets to experienced sponsors. We like the high income returns and downside protection (a roughly 25% equity cushion) in particular during late cycle. Loan-to-value (LTV) ratios remain stable and covenants are prevalent; the relative value and risk-adjusted returns, compared with equity and public credit, are compelling.
- U.S. residential mortgages: We believe non-agency residential mortgages today represent an attractive area, where lenders face limited competition and enjoy high barriers to entry. These are low-LTV loans to highly creditworthy borrowers with very manageable debt-to-income ratios.
- Senior loans: We see opportunity where there is less than 4x or no leverage, meaningful LTV cushions, full financial covenants and exits that won’t rely on capital markets for liquidity. Targets include private loans to small and mid cap public companies.
- Providing liquidity: As forced sellers flee credit markets late in the cycle, providing liquidity to stressed markets may be a way to capture value.
- Credit risk transfer:1 As healthy U.S. consumers pay down mortgages, this market may continue to provide uncorrelated income.
Household balance sheets have not been re-leveraged to the same extent as corporates’
EXHIBIT 2: U.S. HOUSEHOLD DEBT AND DEBT SERVICE RATIOS
Source: Bank for International Settlements, Board of Governors of the Federal Reserve System; data as of December 31, 2017.
ABILITY TO PIVOT TO IDIOSYNCRATIC, DISTRESSED AND SPECIAL SITUATIONS
We see opportunities in distressed and special-situations private credit strategies that, while all-weather, are particularly well positioned to take advantage of current late-cycle excesses and to potentially benefit when the next economic downturn occurs. We will focus on U.S. and European countries where we have deep familiarity, where relationships matter and where significant barriers to entry exist.
Opportunities will likely include medium-size businesses (enterprise value under USD 2 billion) that have valuable hard assets but have been hurt by the actions of less than top-notch management. Distressed investments may continue in industrials, energy and materials, and (building on a history of monetizing intellectual property) in the medical device and specialty pharmaceutical sectors, where we understand patent and regulatory processes.
The increasingly competitive market means manager quality matters even more. Investors should look for continuity, experience and a reputation for sophistication and trustworthiness, along with strong sourcing networks that enable the investment manager to originate high quality deals. To be sure, a sustained recession and consequent erosion of cash flows and collateral values represent a risk to any performing credit strategy. In an environment of market duress, investors should seek managers with critical experience and networks solidified during the GFC. The potential risk of a recession in the next few years also speaks to the need to have a range of private credit strategies—across performing, special situations and distressed— that can flourish in different environments.
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