Private credit, meet higher-for-longer

FINDING opportunities over the past 18 months has been anything but easy.

High inflation had the United States Federal Reserve hiking interest rates at its quickest pace in decades, and transitioning from quantitative easing (QE) to quantitative tightening (QT).

Uncertainty about future rate hikes, economic growth and consumer strength turned the 10-year term premium positive. Ten-year yields reached new highs amid some of the most volatile swings in its recent history.

The traditional 60/40 portfolio provided insufficient diversification, as the stock-bond correlation turned positive in October 2022.

These conditions have many investors wondering where else they can go. At Blackstone, we believe these macroeconomic conditions have the potential to create a favourable market for private credit.

Equity returns enter a different era

Although the S&P 500 has returned an impressive 19 per cent for the year through Nov 15, seven mega-cap tech stocks are largely responsible.

These seven are up an average 72 per cent, while the other 493 stocks in the index are up only 7 per cent.

S&P 500 valuations remain elevated, and history shows subsequent 10-year annualised returns at these levels have historically resulted in lower forward returns.

The last time price-to-earnings multiples were at this level, the index provided only a 7 per cent annualised return over the next 10 years.

Higher discount rates mean equity returns will likely trail those of recent prior cycles, and market risk is more likely to be a headwind in the QT era compared with the massive tailwind that was QE.

In a lower-return environment, with higher interest rates and volatility, investors will be challenged to add value while managing risk effectively.

Simply owning the market will not get it done anymore. During the QE era, market multiples worked in tandem with earnings growth to produce historic returns.

From March 2009, when the S&P 500 traded at 13 times earnings, to August 2020, when it peaked at 23 times, a passive investor in the market earned 16 per cent per annum.

Breaking down the total returns by source from December 2009 to December 2020 showed 44 per cent of the index’s average total return was from multiple expansion.

We take a more muted view for the next cycle as multiple expansion was responsible for only 14 per cent of the average annual total return from 1991 to 2008, when rates were both higher and more volatile.

In a higher-rate environment, earnings growth will drive returns. Quality factors such as the relative strength of balance sheets, earnings predictability and cash flow growth can offset some of the risks inherent in an environment of scarcer returns.

Given that positive stock-bond correlation is stronger during periods of elevated inflation, we believe active portfolio management incorporating private alternatives that have a low correlation with traditional public markets can create a more resilient strategy.

Private credit comes of age

Market forces of supply and demand are aligning for private credit. Tighter lending conditions and the aftermath of Silicon Valley Bank’s collapse caused traditional lenders to step back.

With slower bank and leveraged loan growth, demand for partners in private credit is high. Private credit provided 65 per cent of loans for the leveraged buyout market in 2021, and 86 per cent thus far this year.

The private market offers transaction speed and certainty, allowing lenders to provide liquidity at the most senior portion of the capital structure, with favourable covenants for investors.

Historically, adding private credit to a 60/40 portfolio has been a useful diversifier. From 2015 to 2023, a portfolio that added a 20 per cent allocation to private credit had reduced volatility, higher annualised returns and an additional 140 basis points of income.

Of course, not all private credit is created equal. There will be winners and losers, and skilled managers have an opportunity to stand out.

Managers experienced in due diligence, and with sufficient scale to build out funds with higher-quality collateral and low leverage in defensive sectors, may be able to provide a better cushion.

Others are likely to face pressure and greater volatility in such an untested and uncertain macroeconomic environment.

Investors are often reminded that higher-for-longer interest rates bring the prospect of higher investment yields, but also place pressure on borrowers.

Referencing the Lincoln International Private Market Database allows investors to compare and contrast this point.

The private credit market’s current average interest coverage ratio (ICR) is 1.5 times, although 17 per cent of companies operate at an ICR below 1 when assuming current base rates.

If we assume forward rates of 5.5 per cent, the average ICR of the market is 1.4 times, while 20 per cent of companies have an ICR below 1.

As pressure on borrowers has the potential to increase, we believe this higher-for-longer rate environment creates meaningful dispersion among managers.

Creating high-conviction portfolios

Private credit managers can do several things to mitigate risk in the event of persistent higher rates and a potential slowing economic backdrop.

First, focus on first lien seniority. When economic environments are uncertain or choppy, sitting up in the capital stack can be beneficial for investors.

When investments underperform, the most senior capital sees materially higher recoveries than capital lower in the stack.

This is evident in the liquid credit markets where first-lien loans exhibited a 64 per cent recovery rate versus 24 per cent for second-lien loans, and 35 per cent for unsecured high-yield bonds.

There is a homeowner analogy to make here. If you buy a house, the lender provides you money through a mortgage. You provide the cash for the equity. If you sell your home, you must repay the mortgage before you get your equity out.

In the private credit context, managers are the lender. Private equity sponsors, the owners of the business, are the homeowner. Senior loans get repaid before equity owners get their money, which can mitigate loss in an uncertain economic environment.

Second, emphasise lower-default sectors. Higher rates will pressure borrowers and highlight that, now more than ever, sector selection matters.

We can see this dynamic in aggregate data from Lincoln, where private credit borrowers in the more cyclical sectors are now experiencing default rates of 8 per cent and year-on-year (yoy) cash flow growth of 2 per cent.

At the other end of the spectrum are those private credit borrowers in the less cyclical sectors, which feature default rates of 3 per cent and cash flow growth of 5 per cent yoy.

Certain managers may choose to focus on lower-default sectors, with particular emphasis on stable revenue and low capital expenditure, such as software, professional services and healthcare.

Third, invest in larger companies. Larger companies are often more resilient in the face of economic headwinds than their smaller counterparts, and historically have lower default rates.

Empirical data on the private credit market showed companies with at least US$100 million in earnings before interest, taxes, depreciation and amortisation (Ebitda) have grown their Ebitda over the last 12 months at seven times the rate of those with Ebitda of US$50 million or less.

The default rate of the larger companies has been a fifth of their smaller counterparts.

Larger companies have greater human capital and financial resources with which to navigate changing economic conditions.

Referencing the earlier Lincoln data, 20 per cent of the private credit market did not have sufficient cash flow to cover debt at 5.5 per cent forward base rates.

Of that 20 per cent, over 70 per cent were companies with US$50 million in Ebitda or less. The pressure of higher rates does build, and we believe it will be felt first and most acutely by smaller businesses.

Finally, maintain a low leverage profile. A low leverage profile is a source of meaningful strength in today’s environment.

A low fund leverage profile increases fund liquidity and/or capital available for investment. A low leverage profile also lowers fund risk in the event asset values fall or losses increase.

Private credit funds tend to be 100 per cent levered or not at all, which is substantially lower than the average leverage found in regional banks of 9.7 times.

Overall, pressure in a higher-for-longer rate environment is building. Investment success for private credit in this environment is likely to be determined by how well a manager is prepared.

Joe Zidle is chief investment strategist of Blackstone’s private wealth solutions group. Jonathan Bock is co-chief executive of Blackstone’s business development companies and global head of market research for Blackstone Credit. The views expressed are their personal views, and do not necessarily reflect the views of Blackstone.