U.S. Mid-Market “Fertile Ground” for Private Lenders — Evening Brief – 06.03.24
Private capital has become an essential option for businesses as traditional financing channels have been disrupted by rising interest rates, inflation, bank failures, and other causes.
While the financial markets have stabilized and syndicated loans are becoming more appealing to some than private borrowing, other businesses may prefer private financing for its flexibility, predictability, and speed of execution.
U.S. middle market companies present a remarkable opportunity for private credit strategies in the face of higher-for-longer interest rates, which risk pushing default rates up, according to Man Varagon, the U.S. private credit unit of London-based alternative investment giant Man Group.
Given the debt’s floating-rate nature, high interest rates have enhanced private credit returns. However, with the Federal Reserve signaling a shift away from expected interest rate cuts this year, the potential of persistently higher rates now raises the danger of increased defaults and losses, according to Man Varagon.
Private credit lenders should protect portfolios by focusing on non-cyclical, recession-resistant, or resilient middle-market companies with strong cash flow, according to Andrew Kurtz, portfolio manager at Man Varagon.
“The U.S. middle market continues to be fertile ground for such prospects,” Kurtz wrote in Man Group’s latest Views from the Floor market commentary.
Although private credit remains a broadly appealing asset class for investors, credit selection, structuring, and active management are becoming increasingly important.
Varagon, which specializes in senior secured loans with various covenants to cash-generating, high-performing sponsor-backed enterprises in non-cyclical industries, stated that certain sectors and firms are still being squeezed by tighter lending conditions and rising capital costs.
As a result, this is increasing the number of distressed borrowers. Lenders, however, are becoming choosier, imposing stricter covenants and smaller average holding sizes on new deals as credit risk increases.
“Investors are being forced to reassess the markets discount rate and in turn their required rate of return for taking investment risk, as pressure builds on the highly cyclical, capital intensive, and over-leveraged areas of the economy,” Kurtz added.
According to industry data, the number of loan issuers executing distressed exchanges, which involve replacing existing debt with new obligations or securities with lower face value, longer maturities, or lower interest rates, increased by 133% last year, while typical payment defaults increased by 200%.
Kurtz highlighted specific pockets of opportunities in industries such as B2B services, healthcare, and B2B providers of established software and technology, stating that, “There are approximately 200,000 middle market companies in the U.S., the combined revenues of which, if they were an economy, would rank as the third largest in the world, employing approximately 48 million people.”