Outlook 2024: A promising vintage for private credit
Asia-Pacific asset owners should continue to benefit from private credit in 2024 as companies remain in acute need of financing beyond banks.
However, they will need to be nimble and selective, as there will be increasing dispersion in performance based on factors such as borrower quality, size, industry, and private equity sponsor-backing deals, according to fund houses.
Within the diverse private lending space, some Asian asset owners have begun to look for opportunities in special situations, secondaries, and distressed assets for 2024.
“Tactically, investors may overweight traditional equity or bonds, but for long-term allocations, we have seen alternatives become a staple in clients’ portfolios,” said Gary Leung, head of alternatives for Asia Pacific clients at JP Morgan Asset Management.
Asia-Pacific asset owners, including family offices’ allocations to private credit will continue as part of a hunt for low-correlation with other assets and a potentially more stable return stream, he noted.
“We favour special situations as liquidity becomes a scarcity in difficult markets and we have seen the rise of bespoke lending opportunities globally with high quality borrowers,” Leung told AsianInvestor.
“Private credit secondaries are another area we find attractive opportunities. These are private credit fund investments in a secondary nature - buying fund positions from selling institutions, normally due to the denominator effect,” Leung added.
He said he has seen an increased supply of secondaries as some institutions continue to rebalance portfolios after the slump of public asset positions in 2022.
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In addition, institutions are eager to create liquidity by selling positions in secondary markets as the exit environment has tightened amid muted IPO markets, which reduced cashflow for private market investors, said Leung.
The average private equity limited partners’ (LPs) net cashflow is at an all-time low since the global financial crisis, Leung noted.
“Given this is a relatively new market, the lack of participants means there are more opportunities to find good deals at a cheap discount,” he added.
RISK AHEAD
As high interest rates continue to heighten companies’ operating costs and impact their ability to repay loans as well as cashflow and reserves, Leung said the firm is cautious of the direct lending space and will monitor its development over the medium term.
With sponsor-led lending opportunities declining due to high interest costs and generally lower transaction volumes, the direct lending industry -- which has grown rapidly -- is now loaded with ample dry powder, he noted.
“As such, we have seen increased covenant-lite loans extended to middle-market borrowers due to increased competition. Although the default rate is still low, these loans could be restructured and thus potentially impact investor returns,” he said.
More than half of the $1.5 trillion global private credit market consists of middle market direct lending, which is a highly competitive space where loans mostly go to private equity-sponsored companies.
According to Cliffwater’s data, the default rate was about 2% as of November 2023.
“We advocate that investors should be nimble and allocate to different parts of private markets strategically and tactically, because there is no single asset class or product that will perform across all market cycles,” Leung said.
BE SELECTIVE
In terms of fundraising activities of Asia-Pacific asset owners, Barry Chung, head of private asset specialist sales, Asia Pacific ex-Japan at Fidelity International, noted that senior first-lien loans continue to dominate the market, while some institutional investors, such as family offices, have also begun to acknowledge the potential of distressed assets as high rates weigh on corporate cash flows.
“We do see investors are looking for ways to capitalise mispriced opportunities and taking an active role across the capital structure,” Chung told AsianInvestor.
ALSO READ: Asian asset owners get pickier with private credit
Chung expected private credit managers who focus on senior secured lending to achieve similar pre-COVID-19 yields of higher risk assets without having to take on higher risk.
Fidelity International believes there is a 60% chance of a cyclical recession in 2024. Investors should be overweight on floating rate-based strategies, with a particular focus on lending to defensive sectors and those with business-to-business income streams, he said.
“A cyclical recession demands a conservative approach to credit selection to avoid over-leveraged companies, and a focus on companies where we can have a direct influence over the structure and documentation of deals,” he added.
As the high-rate environment puts the pre-existing private credit portfolios to test on segment allocation and underwriting quality, Chung noted that newly launched funds could be a better vintage with lender-friendly terms and lower leverage levels.
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Sponsors are more inclined to have higher equity cushions, and overall tighter covenants, he said.
“Opportunities across the core and mid-market in the US and the European Union remain attractive. Deal flow remains robust with strong topline growth, lower leverage, stronger covenant packages, naturally simpler capital structure and better lead lender access,” Chung said.
“We believe the vast core and mid-market has been and will continue to be all-weather regardless of economic conditions or competitive dynamics.”
Just as KKR notes in its private credit outlook titled “2024: A Credit Vintage to Remember?”, the opportunity for attractive vintages is exciting looking ahead to 2024 and beyond, as companies’ need for financing continues to support better terms and documentation, while higher-for-longer interest rates support attractive yields.
“As valuations between sellers and buyers continue to converge, we may continue to see headlines about problems in pre-pandemic vintages across private markets,” the alternatives asset manager said.
However, KKR believes it is not realistic to wait for rock-bottom valuations or a wave of defaults.
“There will certainly be some forced selling in certain places, but for the most part, we expect these sales to be idiosyncratic rather than systemic,” it said.