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Private credit has had a great run over the past decade. Direct lenders supplanted banks as the most important credit providers to middle-market businesses and have delivered strong performances so far, albeit in a “benign” credit environment.
Well, things might be changing.
Interest rates are rising, the economy is softening and investors are beginning to ask whether private credit can continue to deliver on its promise of capital preservation and stable income.
Investors might look to the trend in recovery rates for an answer. While default rates are typically a good metric for gauging credit underwriting, the recovery rate, which measures a manager’s ability to recover principal after a default, will be a better metric to identify direct lenders with the right skill sets to drive principal recovery over time and preserve returns in the face of higher defaults.
Default Rates vs. Recovery Rates
To help make this point, let’s look at a typical private credit loan portfolio and see how helpful default rates and recovery rates are at predicting total returns. For this analysis, we modeled a typical pool of direct loans in the current market: first lien, senior secured “unitranche” loans priced at Secured Overnight Financing Rate (SOFR) +6 percent levered 1:1.
In a low default rate environment, a portfolio can do fine with relatively low recovery rates. With fewer deals in trouble, a manager’s ability to drive recovery in these deals becomes less impactful. When default rates increase and managers are dealing with more troubled transactions, their ability to manage those situations and drive strong recoveries become increasingly important.
For example, with a relatively low one percent default rate, even a poor recovery rate of 45 percent can still return close to an 11 percent IRR. Increase that default rate to five percent with the same recovery rate, and the performance drops over 30 percent to a 7.3 percent IRR. With that same five percent default rate, if the manager can achieve a 90 percent recovery rate, the IRR remains relatively stable at 10 percent.
A quick look back at default rates during the last material market downturn – the 2008 financial crisis – highlights what we could experience in the next major downturn. Notably, loan defaults peaked in 2009 at more than 10 percent and remained at or above four percent for more than 18 months.
Managers Need to Maximize Recovery Rates
What can private credit managers do to outperform their peers by driving stronger recovery rates and preserving returns? It boils down to two principles: 1) Building the business around key skill sets grounded in sound underwriting and structuring and 2) practicing active, informed portfolio management.
Here are four core elements to building the business:
Key Skill Sets
Active Portfolio Management
The second principle – practicing active portfolio management – is refined through experience gained over economic cycles. At the first signs of credit stress, managers need to be in front of the issues and engage with borrowers. Here’s three pieces of advice to this end:
If a business continues to underperform, even after additional equity support and operational adjustments, the lender needs to be completely focused on capital recovery.
Further Action items:
So what’s the “punchline”?
Private credit is playing an increasingly important role in investment portfolios. Heading into what could be the asset class’s first experience with an economic downturn and tighter credit conditions, investors are right to question how it will perform when tested. No one has a crystal ball, but one factor is paramount: manager selection.
Avoiding the asset class over the next cycle due to uncertain economic headwinds or the “denominator effect” might not be the best decision given the stable returns and consistent income private credit has delivered. Instead, investors should identify private credit managers with the skill set and track record to preserve capital and ensure returns amid challenging market conditions.
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