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Today's opportunity in the U.S. direct lending space

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After years of investor skepticism over the "crowded" direct lending space, now is an opportune time for investors to consider putting money to work in this market.

Reason one


Private credit funds put to work during recessionary periods have typically outperformed

Although no two recessions are the same — and today's pandemic-driven downturn is singularly unique — private credit fund vintages launched during or immediately before a recession have tended to outperform other vintage years. This makes intuitive sense, since economic downturns typically lead to depressed valuations across many asset classes. Indeed, private credit funds launched in 2001 and 2009 have been the two best-performing vintages on a historical basis.

Chart 1: Private debt fund performance by vintage year


Reason two


There is far more dry powder in middle market private equity funds than there is in middle market debt funds

Many market-watchers have highlighted the abundance of dry powder held by private debt funds, suggesting that this may lead to too much capital chasing too few opportunities. However, investors should place greater importance on the supply of private debt capital relative to private equity capital, since private debt is typically invested alongside private equity dollars during LBOs, acquisitions and other private equity deal-making activity. At the end of 1Q20, there was $444 billion worth of dry powder in middle market private equity funds, versus $95 billion in private debt funds — a ratio of nearly 5 to 1.

What does this mean from a relative value standpoint? The capital structure of a private company typically consists of 50% to 80% debt (or higher), a ratio of one to four debt dollars for every dollar of equity capital. This would suggest that the $444 billion in private equity dry powder will need to be paired with $450 billion to $1.8 trillion in debt capital — a far cry from the $95 billion of available dry powder in private debt funds. This suggests that, in order for this private equity capital to be fully deployed, a lot more debt capital would need to come to market. Either that or private company leverage will need to decline significantly (or both).

Chart 2: The dry powder gap between private equity and private debt

 

Reason three


For the first time in a long time, it's a lender's market

The long bull run in credit markets saw a rise in leverage levels, a steady narrowing in borrowing rates, and a general loosening in lender protections (i.e. covenants), as yield-starved investors competed to lend money to both public and private companies. In the middle market lending space, this trend ended abruptly in March, when the rapid increase in COVID-19 cases — and the ensuing lockdowns — drove many companies to draw down revolving credit lines and reach out to debt and equity providers for covenant relief. Since then, middle market borrowing rates have gotten higher, leverage multiples have declined, and covenants have gotten tighter, reflecting a significantly more lender-friendly market dynamic. Granted, new deal activity has also declined precipitously, as private debt and equity investors have turned their attention to existing portfolio companies under stress. However, middle market lenders with ample dry powder and relatively clean existing portfolios are still finding compelling opportunities to put new capital to work.

Chart 3: Middle market leverage levels

Reason four


Manager selection aligned with sponsor expertise provides better outcomes

Since the Great Recession the importance of active credit selection by managers of middle market loans has taken on increasing importance. Unlike liquid loans, which can be readily sold if performance deteriorates, private credit is a buy-and-hold asset class. By focusing on defensive, asset-light sectors, and by aligning with private equity sponsors with particular investment expertise in those areas, performance in a downturn can be enhanced. Indeed, the current pandemic impacted many of the same cyclical industries – retail, restaurants, travel and leisure – that bore the brunt of the GFC. By avoiding the more consumer-facing companies, the portfolios of select experienced credit arrangers have performed well during some of the worst economic times in our history. Those same lenders have been able to pivot quickly to new opportunities in less-COVID-sensitive areas. That bodes well for future portfolio defaults and recoveries, as most analysts expect economic conditions to improve over the next year or so.

Chart 4: YTD Returns across bank loans, IG corporates, HY bonds, and middle market debt

Middle market debt has been largely left out of this rally, due to a confluence of factors. Differing liquidity levels is likely a key driver; opportunistic funds can be deployed into liquid credit sectors quickly, while middle market debt investing is more deal-driven and resource-intensive. There are also supply and demand dynamics in play, primarily driven by the aforementioned gap between levels of private equity and private debt dry powder.

Conclusion


For patient investors with a long-term time horizon, middle market debt offers a compelling relative value proposition

Today's direct lending market offers attractive yields well in excess of the levels available in liquid credit sectors of comparable quality, even as middle market leverage multiples have trended lower and lender protections have become more robust. Granted, there is less liquidity on offer in the middle market space, and investors will need to be patient and prudent as they deploy into new investments. But for long-term oriented investors with a conservative mindset, today's middle market debt opportunity set warrants a closer look.

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Dimitri Stathopoulos
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Endnotes
Investments in middle market loans are subject to certain risks. Please consider all risks carefully prior to investing in any particular strategy. These investments are subject to credit risk and potentially limited liquidity, as well as interest rate risk, currency risk, prepayment and extension risk, inflation risk, and risk of capital loss.

The views and opinions expressed are for informational and educational purposes only as of the date of production / writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain "forward-looking" information that is not purely historical in nature.

Churchill Asset Management is a registered investment advisor and an affiliate of Nuveen, LLC. "Churchill Senior Lending" refers to the senior secured loan investment team and portfolio of Churchill Asset Management.

A word on risk
As an asset class, agricultural investments are less developed, more illiquid, and less transparent compared to traditional asset classes. Agricultural investments will be subject to risks generally associated with the ownership of real estate-related assets, including changes in economic conditions, environmental risks, the cost of and ability to obtain insurance, and risks related to leasing of properties.

Nuveen provides investment advisory solutions through its investment specialists.