Credit Market Breakdown : Investors’ Appetite for U.S. Private Credit in 2018
This is the first blog post in a series where we delve into the credit outlook for 2018. In the first post, we will explore the outlook for U.S. credit markets and how institutional investors are beginning to shift assets to private credit with the hope of generating higher returns.
Will the Momentum of 2017 Continue for U.S. Credit Markets?
Private debt funds raised a record $100 billion in 2017. Market fundamentals in the U.S. were favorable for alternative credit as interest rates in the U.S. remained low and the economy was improving at a modest but steady pace. The search for yield resulted in the credit markets becoming an attractive option for investors given the decline in government bond yields and the fact that traditional lenders are under regulatory pressure. Since 2007, the private debt markets have tripled to $638 billion in 2017 according to Preqin research.
In this blog post, we will examine the varying viewpoints on whether the credit market can maintain its momentum in 2018 and why institutional investors are increasing allocations to private credit.
Institutional Investor Appetite for Credit Has Been Growing
Institutional investors, more specifically, pension funds, have been increasing allocations to private credit given the low-return environment in equities and traditional fixed income products. The number of active investors in the private debt markets has been growing alongside investor allocations to this asset class, setting up a competitive environment similar to what we are currently seeing in private equity.
In particular, the rapid rise in direct lending funds has been notable within this space. While traditional strategies such as distressed debt, special situations, and mezzanine lending have continued to grow, direct lenders have received a particularly strong tailwind as traditional bank lenders have cut back on business lending in the post-crisis regulatory landscape. The influx of investors into this space, however, has led to a competitive market where lending terms have become more favorable to the borrower.
That being said, the start to 2018 for fundraising within private debt has tempered from the robust pace seen in 2017. According to Preqin, nineteen private debt funds raised $14 billion in the first quarter of 2018, compared to $25 billion for the same period in 2017. While the pace of fundraising has slowed in 2018, investors still have a broadly positive outlook for this asset class.
Economic Outlook for the U.S. in 2018
The current trajectory for U.S. markets faces a strengthening economy, likely multiple interest rate hikes and valuations being near all-time highs. On the one hand, some economists believe credit markets have run their course and that a decline in lucrative opportunities should be expected. On the other hand many believe there is still ample opportunity to run in credit markets, particularly private credit, given how expensive equities have become and how poorly traditional fixed income investments have performed, and will continue to perform if rate hikes come in as expected. We outline the factors below that we think will be key to monitor.
ONE: INTEREST RATES
The Federal Reserve has indicated it will raise interest rates three times in 2018 to tame inflation. This will lead to more pressure on bond markets, and traditional fixed income products.
Distressed investments, in many cases, will struggle as the U.S. economy continues to strengthen. Over the past few years, the pace of distressed investing has slowed, and according to data provider Pitchbook, the number of middle-market distressed debt deals fell to 72 in 2017 from 127 in 2014.
Despite this, distressed investment opportunities still exist for investors, particularly in the lower middle market. Lower middle market companies tend to be more vulnerable to business disruptions such as the loss of a major customer. As of February, there have been six private equity backed distressed deals according to Pitchbook, signifying there are opportunities in the market if investors are willing to pick up a shovel and dig.
TWO: COMPETITION AND BORROWING STANDARDS
In 2017, the pendulum has shifted towards borrowers as lenders offered friendlier loan terms – the result of competitive market conditions. The U.S. is now in its third-longest economic expansion, leaving many pondering how much further this can last. In 2017, favorable lending terms added a lot of debt to firms’ balance sheets, but according to many, not enough value was created. The below graph is a survey of senior lending officers at banks across the U.S. where we see the lending standards, on average, have been easing especially to larger companies in recent quarters.
Leverage levels are higher than they have been in years, causing concern for investors and lenders alike. According to Thomson Reuters LPC data, leverage on middle market institutional deals increased in 2017 to 5.51x total debt to EBITDA compared to 4.95x in 2016. Despite this, defaults have been relatively modest so far and economists and investors alike expect default rates to remain low in 2018 mainly because economic conditions are expected to remain favorable.
Anticipated regulatory reform will also help propel the economy forward in 2018. Community banks and other mid-size lenders will benefit immensely from regulatory reform. Dodd Frank imposed significant financial burdens on smaller lenders from a compliance cost perspective. Realizing there isn’t a one size fits all approach to regulation, rules will be rewritten to ensure lenders of all sizes can operate while still ensuring compliance. With credit more easily available, financial institutions and small businesses will have a strong launchpad for growth.
THREE: LOFTY VALUATIONS AND DRY POWDER LEVELS
Valuations are expected to remain relatively high in 2018, posing challenges to investors, particularly PE, who have significant dry powder levels. Despite borrowing terms becoming more friendly, investors are forced to stay on the sidelines, searching for the “diamond in the rough.” According to a Preqin special report, 70% of fund managers believe there is greater competition for transactions now than twelve months ago.
What does this mean for dry powder levels? The private debt industry reached a record high of $638 billion at the end of June 2017 according to Preqin data. Despite this, investors still have a healthy appetite for private debt. Momentum in this asset class is expected to continue on the same trajectory in 2018 as investors seek opportunities that generate double-digit returns.
Credit markets saw a good run in 2017. While 2018 is off to a relatively slow start compared to the frenetic levels of last year, investors still expect to increase portfolio allocations within credit strategies with a broadly positive outlook if the U.S. economy stays the course.