The Impact of Monetary Policy on Private Markets: Private Debt

The inflation risks in Europe are receding, driven by the decline in energy costs and production factors. Given that economic growth is moderate, conditions are ripe "for interest rates to start falling, possibly as early as the second quarter," says James King, Head of Structured Credit at M&G Investments.

There is a risk that these rate cuts may be delayed due to economic growth being more resilient than expected. The upside of this strength is that it would benefit the corporate world whose models have more beta to GDP growth, "which encompasses private debt issuers," explains Manuel Mendívil, CIO and Co-CEO of Arcano Partners Asset Management. "For private debt investors, and since returns are floating-rate, there is also an improvement in expected returns in 2024 versus the end-2023 interest rate curve scenarios," he explains. The downside, delaying rate cuts, causes a greater debt servicing burden compared to the early decline anticipated. This "will lead to greater performance dispersion in terms of better and worse assets, and could increase the annual default rate," Mendívil adds.

IMPACT OF RATE HIKES

The interest rate environment seen in the past year is not one investors are accustomed to and, according to Daniel Herrero, partner at Oquendo Capital, it has various effects on private debt instruments. As an investment product, asset profitability has increased significantly as it offers variable interest rates that move in parallel with rate hikes. However, the risk of different investments has comparatively increased in some cases, as the financial burden associated with debt also rises. For heavily indebted companies, this could start to pose a threat to their repayment capacity. From the perspective of originating and producing new transactions, rate hikes can result in a setback for new investment processes (organic or in the form of M&A), primarily in large international LBO transactions where leverage effects play a significant role in capital return expectations.

Rate hikes since the third quarter of 2022 led to a domino effect affecting Direct Lending activity. Focusing on Europe, according to Deloitte's Private Debt Deal Tracker (spring 2024 update), activity volume decreased by around 20%. "Activity was sustained by complementary financings for existing portfolio companies and companies seeking Direct Lending as a better alternative to volatile pricing and demand conditions, with an increasing syndication risk in a widely syndicated loan market," states Tikehau Capital.

INTEREST COVERAGE RATIOS

With current European base rates at 4% and margins of 6-7% for mid-market unitranche loans, "the increase in borrowing costs has affected metrics such as interest coverage ratio," note from Tikehau. However, rating agencies' estimates, based on sampling data, suggest that the breadth of the impact is relatively contained, with a small minority of companies having an interest coverage ratio below 1x. There are other factors at play as well, such as "opening leverage, profitability, and margins of a company," they add.

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Source: Bain & Company.

In structured credit (bonds and notes), James King (M&G Investments) explains that rate hikes have increased asset profitability due to the variable rate nature of the structure. "We have observed some moderate increases in underlying collateral defaults, but the overall affordability of debt as a whole for consumers and businesses remains within historical norms, so we are not overly concerned," he adds.

"Higher rates are posing a serious challenge to existing assets in private markets," describes Christian Stracke, Global Head of Credit Research at PIMCO. However, "at the same time, this challenge is creating once-in-a-generation opportunities to deploy new capital in dislocated markets. As things stand, asset revaluation is occurring very slowly in response to higher rates."

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WHAT TO EXPECT WHEN RATES FALL?

The expected start of the interest rate cutting cycle will have several effects on private debt, both in terms of loan profitability and borrower companies. This is explained by José María Fernández, Partner and Co-head of Private Credit at AltamarCAM Partners. In terms of profitability, he foresees two opposing effects: "if reference rates for loans fall, so will their profitability because they are variable-rate. A possible mitigating factor of this decline may be an increase in the spread applied to new loans, as historical evidence indicates that the spread applied to base profitability tends to move in the opposite direction and less proportionately than the movement of monetary rates," Fernández explains. On the other hand, moderation in rates will make it easier for companies to more comfortably manage their financial burden. This is important as the sharp rate hikes since 2022 have increased the interest burden these companies bear, posing a risk to their financial viability," he adds

SHOULD WE FEAR DEFAULT RATES?

There is a high consensus that default rates will increase in 2024 compared to the previous year. However, "there is no fear," says Manuel Mendívil (Arcano), providing two arguments: first, "default rates in the period 2021 to 2022 have been very low, and it is logical that as the economy slows down, this rate will rise"; second, "due to the stronger economic conditions and dynamism of consumption, as well as the low percentage of maturities in the next 18 months."

In the absence of a severe economic shock, "moderate growth in defaults may lead to some more likely losses among more junior investors in the capital structure. But it can also be a source of opportunities to take tactical positions by refinancing viable companies on attractive terms," says José María Fernández (AltamarCAM Partners). Opportunities will arise for those with the capital to invest and who can select companies "whose default is more a result of overleverage or mismanagement than of the future viability of the business," he adds.

"IT'S HARD FOR A COMPANY TO FALL JUST BECAUSE INTEREST RATES RISE BY 4%"

In this regard, Daniel Herrero (Oquendo Capital) states that it is "difficult for a company to fall solely because interest rates rise by 4%. If it happens, it means that the company's fundamentals were deteriorated beforehand." In their portfolio are companies whose performance is somewhat worse than expected due to economic contraction in some markets, "but the equity cushions and cash generation are more than sufficient to contain the risk in this regard," he notes.

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FLOATING STRUCTURES

In this regard, the structure and characteristics of European direct lending "should mitigate any significant increase in default rates," notes Tikehau Capital, highlighting elements such as the close commitment between sponsors and borrowers and a wide range of risk management tools to address difficult situations. "As a reference, S&P has maintained its forecast for default rates in Europe in 2024 at 3.5%, the same as for 2023," they add.

In general, "the best investment opportunities arise when the market expects higher default rates," says James King, Head of Structured Credit at M&G Investments. "When too many investors are pricing for economic perfection, that's when investment conditions are poor." They recommend not trying to predict default rates, as "only the last five years should illustrate the folly of trying to do so."

In conclusion, private debt, for the most part, is structured through floating-rate loans. They do so based on a spread over Euribor (or similar index), in addition to a structuring fee for the operation and possible additional fees if the borrowing entity repays the principal early. This is explained by Daniel Pingarr

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