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Asset Management Viewpoints: The Right Vintage of Private Credit

By Thomas O. Herrick
Chief Market Strategist, Managing Director

Investors looking for diversification beyond public equities and bonds should consider fresh private credit funds. Private credit is a space with a long history of reasonably low default rates and high yields. Our recommended version of private credit is also known as direct lending to middle-market companies. The opportunity set for this loan activity is huge as banks have retreated due to regulatory changes over the last 15 years. Middle-market corporate borrowers incorporate about 200,000 companies in the US, comprising about a third of GDP.

The key timing element regarding direct lending is that base rates have escalated dramatically over the past 18 months. Newer funds raising capital in today’s market are most attractive as the entire fund is capturing those higher base rates. Protective covenants have also grown stronger over that same time period.

Components of a Direct Lending Yield graphic shows Base Rate at 5.4%, Credit Spread at 6.1%, Original Issue Discount (OID) at 0.5%, and Potential Prepayment Premium at 0.2% for a total of 12.2%.

What we’re seeing3

Higher base rates and spreads
3-month base rates have risen nearly 400bps vs one year ago.4 Rising rates mean higher overall coupons as direct lending is typically floating rate.

Stronger covenants
Covenants are protections for lenders in a debt agreement. We have typically negotiated for 1-3 covenants per transaction in Q3 2023 vs 0-1 in Q4 2022.5

Lower “loan-to-value” (LTVs)
A lower ratio of the size of the loan to the borrower’s enterprise value means lowering the potential risk of loan loss for the lender.6

Source: BlackRock as of 30 September 2023. 1Represents weighted average data across the first lien investments in BDEBT purchased in Q3 2023. 2Annualized over weighted average life. 3Shown for illustrative purposes only as an indication of how we believe the direct lending market has shifted since Q4 2022. 4https://www.newyorkfed.org/markets/reference-rates/sofr-averages-and-index 5Sample transaction statistics per BlackRock as of 30 September 2023. 6 Reflects the LTV (“Loan to Value”) and is the ratio of a loan to the borrower’s enterprise value.

 


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