Extra Credit
Can Private Credit Weather the Storm?

In this episode of Extra Credit, Danilo Rippa, Head of Multi-Strategy Credit at Man Group is joined by Kevin Marchetti, co-Head of Direct Lending and Chief Credit Officer, and Zeshan Ashfaque, Senior Credit Officer at Man Varagon. Private credit has grown significantly over the past decade, representing a secular shift in how companies access funding – and how investors are allocating to credit. This far-reaching episode offers insight into trends in lending, yields, syndication and how they may – or may not – be impacted by an uncertain economic environment.

Introducing Extra Credit, the latest season of Long Story Short

The world of credit is evolving. Gone are the days when investment grade bonds were only sold over the phone and the world of direct lending was a little-known niche. Corporates now have a multitude of ways to access capital and investors can diversify their credit allocation more than ever before. Extra Credit, the fourth season of our Long Story Short podcast, will explore the ways credit is changing and how it fits into your portfolio. Hosted by Danilo Rippa, Head of Global Credit Multi-Strategy and Global Convertibles at Man Solutions, this season will feature experts from across the credit investing spectrum.

Recording date: April 2024

Episode Transcript

Note: This transcription was generated using a combination of speech recognition software and human transcribers and may contain errors. As a part of this process, this transcript has also been edited for clarity.

Danilo Rippa:

Welcome to Extra Credit, the latest season of our investment podcast, Long Story Short. I am Danilo Rippa, head of credit multi-strategies and global convertibles at Man Solutions. Joining me today are Kevin Marchetti, co-head of Direct Lending and chief credit officer, and Zeshan Ashfaque senior credit officer. Both experts in private credit. Thanks for joining us today. So let's start with the first question. Obviously there is no denying that private credit was perhaps the most desirable asset class of 2023, but can you please give us an overview of the world of private credit?

Kevin Marchetti:

Yeah. It's a fantastic question and when you pull up and you think about the market landscape of direct lending within the world of private credit, it has significantly evolved over the last two to three decades, which has seen providers of private credit take substantial market share of the US loan market from the traditional providers, the banks, within the US world. The great financial crisis and the added regulatory requirements of banks have further resulted in the banks holding less of these loans that originated in our core middle market and the large cap market, which we'll talk about a little bit later. What does that translate into? When you think about in 2023, I believe the ratio of direct lending volume provided by private credit providers like Man Varagon to that of the syndicated loan volume was at about five times ratio.

So significant market share continues to be taken by private credit providers and the proliferation of the asset class has been pretty substantial. And I think last year it was even exacerbated further by the regional banking crisis that happened in 2023, which we believe will further drive incremental opportunities to the core middle market where we play. Levered lending guidelines, et cetera, will continue to bog down those more regional level banks. And I think the asset class has continued to overall provide and deliver attractive returns to investors with low volatility as the markets continue to evolve and people have seen that.

And I think when you think about 2024 and where the asset class is and the opportunity set, obviously M&A volumes were down in 2023 as a result of the rate environment, but as we have more conviction now around where rates are going, the likelihood of potential rate cuts at some point on the horizon, but less concern about further upticks, I think we're cautiously optimistic you're going to see a nice recovery in refinancing activity and a nice recovery in new M&A activity, which will bode very well for providers of private credit and continue to grow the pipeline in 2024 for an opportunity set perspective.

Zeshan Ashfaque:

In addition to that, I would say that one of the things we watch closely is the maturity wall of loans that were originated in years past. As those loans come due, there will be opportunities for direct lenders to step in and provide additional capital to refinance those or quite frankly solve other problems that may be out there. So we think there's going to be a healthy pipeline for private credit, not only in particularly the back half of '24, but next year and the years to come as well.

Danilo Rippa:

Thank you, Kevin. But something that really strikes me is why now? What's driving this massive interest in the subsector of the credit universe? Do you believe it's filling a vacuum or is it taking the place of other asset classes like private equity or even traditional loans?

Zeshan Ashfaque:

I think it's been a combination of both of those factors. So Kevin touched upon the structural changes in the lending world with the banks retreating as a result of greater regulations that were passed post-financial crisis to help control and minimise systemic risk. That created opportunities for private credit funds to step in and provide capital to smaller middle market companies and more increasingly larger upper middle market broadly syndicated loan companies. So you've had direct lenders step in as banks have retreated, but also taking on more share and diversifying into other pools of assets and we expect to see that continue as different asset managers focus on sub-strategies within private credit, whether it's direct lending, asset-based deals, special situations, et cetera.

Kevin Marchetti:

And I would just add to what Zeshan said. I think it isn't just filling a vacuum, when you think about just the fundamentals of the market. I think in 2023, dry power in the private equity world for capital raise reached about, I think it was about two and a half trillion dollars. And when you think about the capital raised over the last, I think since 2015, for every $10 of private equity capital raise, there's only been about a dollar of direct lending capital. So when you take that fundamental dynamic of available capital to deploy and then you think about the middle market in the US, there's 200,000 plus small to medium businesses, that drives a fundamental pipeline of opportunities that we believe will last for the next several decades. So to couple onto what Zeshan was saying with the retreatment of the banks, et cetera, that pipeline of opportunities is there, the desire for financing is there, and the need from private credit will continue to be there from an asset perspective.

Danilo Rippa:

Let's focus a bit deeper now on core middle market. What sets this sector apart from large cap or even upper middle?

Kevin Marchetti:

Yeah. Look, I think it's fascinating how this market landscape has really evolved over the last decade specifically, but when you think about the private credit world within the US, it used to just be everyone thought about it as the middle market. And what you've seen over the last decade because of the capital raise, there's very large providers that have raised and accumulated significant dollars in terms of fundraising that have moved up to compete with the legacy broadly syndicated loan market, the upper middle market, the large cap world. Those are the mega unitranche deals. That's the stuff you read about in the rags. And those are covenant like type deals, looser documentation, very large deployments, deploying 500 plus million dollars in a loan.

And then you kind of factor in what is the core middle market? And we define the core middle market as kind of 10 million of EBITDA to 75 million EBITDA size companies, but really think about it as 10 to $40 million EBITDA sized businesses in the US. And why we're so excited about that and what you think about the differentiation between that market and that of kind of the larger cap world, there's a few things. I think first from a relative value aspect, there's a couple things we really like, right? Structure, protections, et cetera. All of the financing we provide have financial maintenance covenants. That exists in the core middle market. You have better rigour around your underlying loan documentation with respect to reporting, financial reporting.

Requirements that that company has to adhere to on a quarterly basis. We have good granular visibility into the underlying performance of those companies. The documentation's also much tighter with respect to other aspects of that company could do, whether they can go get other debt outside of our credit facility, whether it's senior debt or junior debt, et cetera. There's restrictions on collateral and cash that can leave your borrower system, et cetera. That all exists in the core middle market. And then the other element I think, we, at Man Varagon, are focused on private equity backed companies. Every financing we do is owned by a private equity firm. In the core middle market, relationships still very much do matter. We're working with private equity firms that cover our market. We're working with the partners and the VPs that own those assets. We're not working with private equity firms that have capital markets desks and it's a race to the bottom on pricing in terms and relationships do matter.

We have 20, 30 year relationships with these firms and we get many of our opportunities coming to us under exclusivity, which we very much like.

Danilo Rippa:

Can you explain to us the role of sponsors in these transactions? What do they actually do and what are you most looking for?

Kevin Marchetti:

I think from a sponsor perspective, there's a few things that they add. First and foremost, they're bringing significant dollars to the capital structure. Right? You're talking about very well capitalised businesses that we finance. Loan to value's about 45% so there's huge equity checks invested by these private equity rooms. They have a vested economic interest. You also are working with an institutional investor that brings significant amounts of operating expertise and operating executives to the mix. They're enhancing management teams. They're bringing in consultants to help drive further efficiencies. They also add an element of inorganic growth to these companies, right? Their support add-on acquisitions for these businesses and grow inorganically through their hold period.

And then quite frankly during periods of dislocation or where there's situations where things may not go according to plan, private equity firms step up and invest further equity into these companies to help bolster balance sheets, fortify balance sheets, and bolster liquidity. So I think you get that added expertise around the professionalism of the underlying borrowers that we work with.

Zeshan Ashfaque:

It's important to add though that while the sponsors provide significant value and expertise to these businesses, every credit investment we make has to stand on its own. The existence and the backing of the sponsor is an important point, but ultimately, credit collection is the most important thing and is the first line of defence on the performance of the portfolio.

Danilo Rippa:

Okay. Let's switch. I would say these are all bottom-up aspects, but let's talk about macro and top-down. This might be a bit controversial, but how is private credit positioned to respond to times of economic stress and uncertainty? How should we think about manager differentiation?

Zeshan Ashfaque:

We think private credit is very well positioned to withstand, quite frankly, all aspects of the economic cycle. You asked specifically about downturns and slow periods.

Danilo Rippa:

Yes.

Zeshan Ashfaque:

With respect to that, Kevin touched on this earlier, within private credit, direct lending, and very specifically the kinds of deals that we do at Man Varagon, we are very focused on selecting credits that operate in industries that are recession-resilient or resistant, limited cyclicality, if any at all. And on top of that is prudent structures. So these are senior-secured first-lean loans at the top of the cap stack with significant equity behind us supporting each company. And within that structure, we have financial covenants and other maintenance, affirmative and negative covenants, that allow us to get back to the table and address any softness or underperformance are too late.

By contrast, when you look at larger market credit, they typically do not have these protections in place and by the time lenders may actually have the contractual ability to do anything, it might be too late. So for us, it's important to have those triggers and mechanisms that allow us to take action more quickly and additionally, the availability of information through frequent financial reporting as well as direct access to management, private equity sponsors, allow us to take action to stay ahead of the curve.

Kevin Marchetti:

And the only thing I would add there is your part of your question that's talking about differentiation in Manager Alpha. Right. Let's be intellectually honest. The last decade, up until about 12 to 18 months ago, we were in a free money world and everything was up and to the right. It was impossible to pick a bad credit that you couldn't get refinanced out of. I think the last 12 to 18 months have been very, very interesting as base rates went from zero to 540 basis points in the period of nine to 12 months. And what we're really focused in on and telling people they should be laser-focused in on with respect to credit is the leading indicators that we're tracking, right? So it's risk rating migration within portfolios. It's percentage of fair market values that are below 85% of par. Right? It's the non-accruals and gross to net losses.

Looking at those in connection with your manager and how they're performing quarter over quarter. And it's looking at kind of just true benchmarking of revenue, EBITDA, financial maintenance covenant defaults to that of a peer set that you can put together. And really what you're starting to see, and it's fascinating, over the last 12 months is you are starting to see differentiation. You are starting to see proof points that certain managers did have better credit selection criteria over the last two to three years and in fact did put more sustainable capital structures on those underlying borrowers the last two to three years. So I think it is very, very interesting. I think now is a period of time where that differentiation's really going to matter as people start to think about allocating more to the space going forward.

Danilo Rippa:

Kevin, what's the risk that concerns you the most? Are markets underestimating the liquidity and default risks?

Kevin Marchetti:

I think the largest impact in our space, specifically in the types of companies that we finance, is really just the rate environment. When you think about all of the factors that have impacted companies, the largest strain on cash flows and liquidity is the higher rate environment. And while we're pretty well insulated today with respect to our weighted average interest coverage, et cetera, I think the longer we maintain higher rates and there's an elongation of when cuts happen, that is going to be the biggest strain on companies. It's going to limit growth investments in those businesses. It's going to require companies to make tougher decisioning with respect to hiring and cost structure decisioning. And I think that is the biggest impact.

When you think about the inflationary challenges, whether it's input costs, whether it's supply chain, whether it's labour and wage rate, I think those factors, it's really kind of the labour side, that's the second-biggest factor. Right? Wage rate pressures because of a lack of available labour is still a true issue across the sectors that we invest in. So from my perspective, those are the two biggest things that we think about impacting the cash flows and the underlying performance of the companies that we have today.

Danilo Rippa:

I mean, these are very sophisticated points, but let me ask you a more cynical question. Is this becoming a crowded market?

Kevin Marchetti:

I don't think it's a crowded market and we can get into this in more detail, but I think when you think about the differentiation between the upper market that we talked about earlier and the core middle market, when you really think about it, Man Varagon's the last new entrant into the space 10 years ago. And then the proof point in the crowded market or unique opportunity is when you think about our origination engine, looking at 1,500 plus opportunities in any 12 month period of time and our strategy, private equity backed, performing companies, senior secure financings, our largest overlap with our closest competitor is about 12%.

So when you think about the unique deal flow, when you think about the opportunity set, I do not believe it's a crowded market because what people don't fully appreciate is the relationship element that I talked about. To get quality deal flow you have to have entrusted relationships with private equity firms in the core middle market. That does not happen overnight. You have to do that over a 10, 20, 30 year period and I think we have that. So I think it's not a crowded market for where we play today and I think that there's not a risk for our portfolio or opportunity set as a result of that.

Zeshan Ashfaque:

I'll add a couple of things that Kevin touched upon earlier, which is the size of the middle market. It's massive. There's about 200,000 to 300,000 companies that make up the middle market with aggregate revenues of estimated $13 trillion, which to put in perspective is around half of US GDP. That is a massive market to play in and we continue to see opportunities. Kevin touched on our lack of overlap with our competitors and we think this is going to continue into the future. Tremendous number of good companies out there that are continuing to grow, have a reason to exist, and make great candidates for direct lending leveraged loans.

Danilo Rippa:

As a final question now, I'd like to understand a little bit more about your conversations with investors and more specifically, how should people think about it from a portfolio constructions point of view?

Kevin Marchetti:

Yeah. I think, look, over the last decade in the proliferation of private credit, it's absolutely became a dominant asset class with respect to how people think about building an allocation directed to that within their portfolios. I think it's proven not only over the last decade, but specifically during the COVID timeframe and most recently over the last 12 to 18 months when the higher rate, it's providing very durable, consistent returns with low volatility and its current cash pay part of your portfolio that can offer an attractive risk adjusted allocation for you is an overall allocation mix and I would expect that to continue to be an even more substantial portion of people's allocation.

And really, you think about how people can allocate and access that. You have multiple strategies within private credit. You can access your allocation through performing middle market companies in the form of senior secured loans like us. There's distress, there's opportunistic, there's people that focus on very specific sectors, et cetera, but all of those aggregate to low volatility in terms of performance and cash paying coupons and I think when you think about that allocation mix, it offers some attractive benefits to investors overall.

Zeshan Ashfaque:

Yeah, absolutely. I think the way to think about the value prop of someone like a Man Varagon is we're providing you access to middle market direct lending, which gives you a combination of capital preservation, current income generation, and within that return is an embedded interest rate hedge through the floating rate environment. So we view this as a core component that provides stability in our client's portfolios.

Danilo Rippa:

Excellent. Kevin, Zeshan, thank you for joining us. It's been great to have you here. Thank you.

Zeshan Ashfaque:

Thank you.

Kevin Marchetti:

Thank you.