In a market environment shaped by higher interest rates, low growth and greater volatility, investors and asset managers are adapting by increasing allocations to alternative investment strategies. Among the unfolding shifts, private credit strategies are rising to the fore as higher rates increase the attractiveness of this asset class. 

In an email interview, Connect Money asked Igor DaCosta, Managing Partner, Portfolio Advisors and one of our panelists for Private Credit: A Complementary Source of Return at Connect Money’s inaugural Alternative Assets Conference on June 14 in Chicago, about the surge in private credit deals given the high interest rate environment; his thoughts on the growing popularity of unitranche facilities; the challenges private credit faces; and his outlook for the remainder of the year. 

More than a decade and a half after the evolution of the private credit industry, its status continues to grow.  

Connect Money: Is private credit currently benefiting from difficulties in other parts of the funding market, particularly in syndicated offerings? Has the post-pandemic world proven to be fertile ground for private credit, particularly as private equity sponsors have been sitting on plenty of dry powder and looking for debt to fund acquisitions? 

DaCosta: One of the benefits of the private credit market is its ability to provide certainty of execution (at a known price) and thereby a safe haven for sponsors in volatile times – whether due to the pandemic or other factors.  Volatility also puts an increased premium on knowing who you are partnering with on transactions, further playing to the benefit of the private credit markets.  Additionally, private credit offers more flexibility around covenants, credit ratings, and pricing (i.e. PIK interest option to address cash interest coverage concerns in a high interest rate environment) relative to the broadly syndicated market which tries to make one size fit all. 

Sponsors and borrowers are increasingly looking for longer-term partnerships, with private credit solutions offering additional flexibility, reliability and speed of execution.  

Connect Money: Have you seen a dramatic increase in unitranche facilities given their streamlined approach? Are these arrangements providing higher leverage solutions and moving into ever-larger deal sizes? 

DaCosta: Unitranche certainly has a role to play in credits where junior lenders may be less comfortable in a secondary position – for example a cyclical/volatile business. Increasingly, sponsors have become aware of the importance of understanding any structuring that may exist behind unitranche structures which has diminished the appearance of streamlining.  

For sophisticated sponsors with strong relationships, a senior/junior structure can not only provide more flexibility but also a lower cost of capital. In addition, senior/junior structures can typically provide sponsors more leverage, especially during higher interest rate environments given the junior debt’s ability to PIK a portion of their coupon to manage cash interest coverage.  

In addition, senior/junior structures are particularly efficient from a pricing standpoint for acquisition strategies, where more traditional (and cheaper) incremental first lien debt can be used as the primary source of acquisition financing versus using additional higher priced unitranche financing.  

Connect Money: What challenges has the current macroeconomic and monetary policy environment created for the private credit sector?   

DaCosta: The macroeconomic and monetary policy environment have brought with them a set of problems for managers that many have not had to deal with before, whether it was the direct impact of the pandemic, inflationary pressures, significant supply chain disruptions, or labor availability and cost. At the same time, higher interest rates have decreased the margin for error and forced sponsors to adjust business plans that might have been partly dependent on excess free cash flow to, for example, pursue acquisitions. 

Connect Money: Have private credit funds reduced their position size in debt facilities to account for the riskier climate?  

DaCosta: Prudent managers should always look to keep a diversified portfolio. Personally, we don’t manage risk by reducing exposure. We pursue credits we believe can navigate varying economic environments and present good risk/reward opportunities vis-a-vis what we promised our investors. 

Connect Money: What is your prediction for private credit as we go through the second half of the year?  

DaCosta: As the economy slows, increasing default rates are inevitable but the more patient nature of private credit holders and their willingness to work with sponsors should help relative to past downturns. I expect volume to pick up in the second half of the year, as the volatility we have observed in the first half of the year has made sponsors more reluctant to bring their assets to market. However, at some point they have to transact and as we discussed before private credit provides greater certainty around execution. 

Don’t miss the Connect Money: Alternative Assets Conference on June 14 in Chicago at the W City Center. Meet private credit experts like Igor DaCosta, Managing Partner, Portfolio Advisors.