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Private Credit Interest Focuses on Relative Value and Downside Protection

Private Credit Interest Focuses on Relative Value and Downside Protection
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Private credit fundraising has remained strong through 1Q23. In the current rate environment, a renewed focus has been placed on relative value, downside protection, and managers’ internal workout resources.

There is also interest in strategies with strong collateral protection such as asset-based lending. And larger sponsor-backed lending is seeing a new focus due to the high yield/BSL disintermediation by private debt.

  • As interest rates declined after the GFC, private credit attracted increased interest from institutional investors.
  • Private credit fundraising was robust leading into the COVID dislocation with a particular focus on direct lending, asset-based lending, and distressed strategies.
1Q23 Private Credit Fundraising Trends
  • During 1Q23, clients took a new look at upper-middle-market direct lending as all-in spreads have widened by over 400 bps and lenders are able to get tighter terms. Strong deal volume was driven partially by a shift from public to private market debt financings in the recent market environment.
  • As economic headwinds are expected to create stress on over-levered companies, there is also interest in stressed and distressed investment opportunities.
  • Demand continued to be strong for less-competitive areas of private credit with high barriers to entry and attractive risk/reward opportunities such as specialty finance and opportunistic lending.
1q23 private credit
  • The recent bank dislocation has provided new opportunity to pick up regional bank assets at a discount as well as to provide capital solutions to bank balance sheets.
  • LPs are seeking alternative structures designed to streamline the investment process while improving underlying liquidity. A number of GPs are launching evergreen structures and private, non-tradeable business development companies as a response to LP interest.
  • U.S. sub-investment grade corporate yields rose dramatically at the beginning of 2022 with yields peaking in September. This was a combination of higher interest rates due to tighter Fed policy and a widening of high yield spreads.
  • Spreads widened during the first half of 2022 due to weaker credit conditions as the U.S. economic outlook worsened. This has since moderated.
  • Default rates for U.S. corporate bonds ticked up in 1Q but remained well below the historical average of 3%-4%. Callan expects defaults to increase somewhat in coming months as economic growth slows and potentially turns negative.
  • The Corporate Bond Market Distress Index (CMDI) rose rapidly during the first nine months of 2022, especially for investment grade bonds, highlighting market volatility and a drying up of liquidity, but has fallen since then.
  • In 2023, as the IG distress index continues to fall, the HY bond indicator is on the rise. The CMDI incorporates a range of indicators, including new issuance and pricing for primary and secondary market bonds and relative pricing between traded and nontraded bonds.
  • Private credit performance varies across sub-asset class and underlying return drivers. On average, the asset class has generated net IRRs of 7% to 10% for trailing periods ended Sept. 30, 2022. Higher-risk strategies performed better than lower-risk strategies.
3Q22 Pooled Horizon Net IRRs by Strategy

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