Speaker 1 00:00:12 Welcome to the Lending Lowdown. I'm CJ Doherty, director of Analysis at Refinitiv lpc, and I'm delighted to be joined by Fran Byers, managing director head of capital Markets at Cliffwater, and an old colleague of ours here at r Refinitiv LPC before she went on to it. Exciting things at Cliffwater. Uh, so welcome Fran. Thanks for joining me.
Speaker 2 00:00:31 Thank you CJ, for having me. It's a pleasure.
Speaker 1 00:00:34 Great. So, so today we're gonna look ahead to the direct lending market in at 2023. You know, at this time of year, everyone in the market is always trying to gauge what might be in store for next year. Not an easy task given the uncertain economic environment we face, but we'll do our best today. So to kick it off, Fran, you know, I think, you know, we at Refinitiv, LPC recently surveyed the B D C market and asked what lending deal flow could be like in the first half of, of 2023 compared to the second half of this year. And, and the results point to activity being flat to up by less than 10%. So what's your outlook for deal flow and also pricing in the direct lending market in, uh, 2023?
Speaker 2 00:01:15 So I think, I'm gonna take the pricing question first because it's easier <laugh>. Um, I can't see spreads moving any higher at this point. I think they're gonna be flat unless the syndicated market opens back up and puts pressure on direct lenders to become more competitive, in which case you could see spreads tightened modestly. CJ the math just doesn't work for spreads to keep moving higher, especially given where base rates are. But, you know, at the same point, I don't necessarily see spreads tightening dramatic dramatically either due to a more uncertain and worsening macro environment. Um, particularly what e economics are projecting is certainly getting worse. And so, um, we also need to see kind of what happens to spreads in the financing market as they are often correlated to new issue pricing as well. Um, deal flow much harder to predict because there's a lot of unknowns.
Speaker 2 00:02:15 I would say year over year. I do believe 2023 is gonna be lower than 2022, but I could see a situation where the first half of 23 is modestly higher than what we saw in the second half of this year. So I, I would agree with the survey respondents. Um, on one end, you know, private equity shops have a ton of cash. They've raised 1.5 trillion over the last four years and they certainly want to transact and that includes sales. We've seen a lot of sale processes getting pushed into the new year given how volatile the conditions have been. So folks are kind of hoping things stabilize and they can sell more in the first half. And I do believe direct lenders are still open for business and they are looking to lean in and capitalize on the current BSL dislocation. But on the flip side, the bid ass spread between buyers and sellers is widening. Economic growth is slowing, you know, the macro picture is very uncertain and deteriorating and that never bodes well from NA deal making. So overall, too many wild cards to really predict and I do believe 2023 has the potential to be a very challenging and volatile year.
Speaker 1 00:03:29 Okay. So, so moving on to talk about portfolio company performance. You know, you just mentioned there that there, there there are risks given like economic uncertainty and then you have inflation higher interstate costs and, and margins under pressure for borrowers. H how do you see portfolio company performance and credit quality playing at next year?
Speaker 2 00:03:47 Yeah, so, um, for those of you that may not know at cliffwater, we actually have a cliffwater direct lending index that tracks performance in the private credit space. And we just published the results last week and non accruals, you know, as of nine 30 were still near record record lows at only 1.26%. So that's well below the historical average of around 2.24%. So what that shows is that, you know, middle market borrowers have been navigating inflation supply supply chain issues quite well over the last 18 months. Meanwhile, if direct lenders are looking at their portfolio, they're continuing to see revenue growth and there's 100% been margin pressure. I don't think anyone can deny that, but it hasn't been at a level that's causing defaults yet. And so let's talk about rising interest rates cuz that's the biggest issue moving forward. We're not yet seeing any change to pick rates within the index through nine 30.
Speaker 2 00:04:49 We're not yet seeing borrowers approach bank groups in mass looking for interest rate relief. With that being said, the numbers are backwards looking. The full impact from rising rates certainly has not flowed entirely through the numbers yet. And math is math. And so we would expect in 2023 you're gonna see the non accrual rate move higher. Borrowers are gonna start to come back to the bank groups asking for interest burden relief. Direct lenders do feel confident that sponsors are gonna support these borrowers and it helps that direct lenders mostly underwrote defensive credits in high growth sectors. So sectors with high variable cost structures, lower fixed costs, those type of companies have more levers to pull to weather the macro environment versus highly capital intensive businesses. However, those higher margin businesses also have more leverage on their capital structure and those deals were underwritten in a 1% base rate environment. So, you know, all in all my thesis is sponsors, you know, they paid record high multiples for these companies. They have a lot of equity capital at risk. So what we're gonna see is together lenders and sponsors are gonna have to find solutions to help these borrowers weather higher rates next year.
Speaker 1 00:06:10 Okay, great. A and uh, you know, I think, you know, the private credit markets ha you know, they have grown dramatically in recent years and our, our recent survey points to BDCs, for example, not growing at the same pace, um, you know, next year as it as we've seen in the last two years. So what's your outlook for fundraising in the, the overall direct lending market next year?
Speaker 2 00:06:31 Um, so compared to the last two years, I'd have to say fundraising's likely to slow down pretty meaningfully in 2023. And there's a few reasons. Let's look at the investor base. So first looking at the institutional channel, you're seeing a lot of pension funds struggling with the denominator effect. So as their traditional portfolios are taking big valuation hits, many are now overallocated to alternatives. So that makes it much harder for them to write new checks. In fact, you know, we're already seeing a material pickup in secondaries as some LPs are trying to sell some of their fund holdings to try and bring those allocations back into balance. So that's gonna continue. Um, in the last few years we've seen big allocations coming from institutional investors in Asia, for example, that ultimately came to a standstill at the end of this year in the fourth quarter.
Speaker 2 00:07:30 First due to, you know, growing concerns for the US economy, these foreign investors are observing the dislocation that's going on in the US leverage loan market. It's giving them pause and second and secondly, and most importantly, it's the rate of volatility in FX rates versus the US dollar and other currencies has jumped to unprecedented levels. And so it's lowering the returns in Asia, for example, anywhere from three to 5% in their local currency and they didn't budget for that. So there's hope that those investors in Asia begin allocating again in 2023 as effects rates stabilize and move back into balance. But it's gonna take a couple quarters for these folks to get comfortable then no moving to the wealth channel. Cj, which, you know, to your question on BDCs wealth channel has been a big driver of the growth in the perpetually private BDC vehicles.
Speaker 2 00:08:22 You are definitely seeing inflows slow. Um, many of these investors, they're becoming a little bit more risk averse. They're also trying to rebalance their portfolios. However, I do believe wealth is a bright spot, it's very underallocated to direct lending today. And so while these flows are slowing, they're still coming in and they're still positive. So we believe that segment of the market is going to be a long-term driver of growth in our space over the next five to 10 years, but they're not gonna funnel money into loans next year at the same pace that they did the last two years. And then my last point here is, you know, given the rise in rates, you simply have more investment options to choose from, like cash, <laugh>, treasuries, and you're starting to see folks see bonds as more attractive again. And so those areas are probably gonna take some share away from private credit in 2023.
Speaker 1 00:09:19 Okay, great. And, and now Fran, I just wanna touch on something that was in the news recently. Uh, the Blackstone private credit fund has seen explosive growth since it was introduced, you know, nearly two years ago, and it now has over 50 billion in assets. Um, notably though, you know, it recently was announced that it hit its 5% redemption limit in in the fourth quarter a and this was the first time this has occurred. I, is this a sign of a change in the broader market?
Speaker 2 00:09:46 It's a good question. Um, I would say, you know, across the space inflows are slowing and redemptions are moving higher, but not all of these redemption type vehicles are seeing 5%, some are seeing less, some are seeing more. And there's a few important points to consider as to why first and most critical is looking at the underlying investor base of each of these vehicles because investors come with their own unique characteristics and risks, right? So for example, vehicles, you know, some of these vehicles that may have high concentrations or chunky investor bases are at higher risk of going above 5% and staying there, right? Should that chunky investor base run into issues and wanna get their money out. On the flip side, concentrations can also work in a manager's favor. If that investor base is a group of sophisticated institutional investors who typically take a longer term view of the asset class, they may be less inclined to exit dues of volatility.
Speaker 2 00:10:53 So it could go hurt you or it could help you. Those managers, um, that have a heavy mix of foreign investors, particularly Asia, they're dealing with a lot of margin account or currency swing pressures that can result in higher redemptions. And then the next big point to consider in these vehicles is valuation. If folks do not believe the marks on the underlying assets are moving fast enough or reflecting true value in a private vehicle, the those investors could be incentivized to punch out, take that cash and go buy public or traditional securities at a much lower valuation. Right? So this is more common in some of the real estate funds and to some degree some of the private equity tender or interval funds. You're less likely to see this dynamic in private credit because valuations tend to be more current and you have less public alternatives with a comparable yield to substitute, but something to consider, third is performance.
Speaker 2 00:11:55 If investors for whatever reason are unhappy with performance over the near to intermediate term, it does raise the likelihood they will exit and reallocate elsewhere. So for example, if investors are seeing big swings in unrealized markdowns when they thought it was gonna be more stable, or if you start to see a pickup in non accruals, it could raise the likelihood of investors punching out over the next few quarters. The last point I'm I'd like to make on these vehicles, particularly these perpetually private BDCs, they're a newer phenomena in the market. It's very tricky to balance having enough liquidity to manage redemptions while also staying deployed to maximize your yield, right? There's a balance there. And so while a lot of these investors in these vehicles believe they have some level of liquidity up to 5% of nav each quarter, the managers do have the option to put the gates up and say, I'm not gonna fill that 5% order.
Speaker 2 00:12:57 And so the reason why this is so topical and closely watched is because again, these are newer vehicles, we haven't seen them go through a downturn and it comes down to the manager in terms of how they prepare for these redemptions and the decisions they make as to whether they fill those redemptions or not. Managers that honor the redemption requests are gonna give their investor base more confidence that they do have liquidity, but managers that don't and they consistently put the gates up that can have reverberations on sentiment for everyone in the space managing these redemption vehicles. So it will be interesting to watch, you know, longer term.
Speaker 1 00:13:34 Okay. Yeah, so, so plenty to watch going forward. Uh, and given we're running outta time, uh, final question for you, you know, using your crystal ball, what is the biggest opportunity and the biggest risk for direct lenders in 2023?
Speaker 2 00:13:47 I don't have a crystal ball. Cj, maybe a magic eight ball. Um, you can shake it up, but, um, <laugh> the biggest, in my view, the biggest opportunity next year is for direct lenders to do exactly what they told their investors they were gonna do, outperform and deliver a high single digit return that they promised investors, okay, this is an all weather asset class. We try to beat, you know, liquid loans and, and other asset classes. So if they can do that next year during a really tough macro environment, my view is the sky's the limit for private credit's growth over the next five to 10 years. The media, no offense, cj, the media has been very unkind <laugh> in the last six months writing a lot of worrisome headlines about the risks in private credit. Meanwhile, I work with managers across the space. I continue to see a big difference in the quality of deals that direct lenders finance versus what gets done in the syndicated market.
Speaker 2 00:14:47 I am a big believer in what these direct lenders do and their position in the ecosystem. You know, furthermore going into next year and we're seeing it now, direct lenders are getting a real opportunity to right size pricing, leverage levels and the docks within their existing portfolios. Cuz sponsors are coming back to the in to do incrementals. They have no competition, right? The BSL market's been dislocated and so it's a huge opportunity for direct lenders. Now banks will eventually start underwriting again, but until they do, direct lenders are going to lean in and pick up assets at very attractive terms. So as long as private credit managers stay liquid, they stay on top of their credits and they're firm and asking sponsors to support these borrowers, I'm hopeful they're gonna weather the macro next year that's gonna speak volumes for the asset class. Now, on the flip side, the biggest risk is of course, number one, some sort of exogenous shock that folks aren't prepared for.
Speaker 2 00:15:44 We saw something like that during C O V, but equally troubling is a long drawn out period of slow or negative growth amid high interest rates, high leverage levels, and that simply crushes borrowers. You know, that that's the fear. But if that happens, cj, it's gonna hurt everybody. It's not gonna just hurt direct lenders, it's gonna impact the BSL market, it's gonna impact the high yield bond market. Equities is gonna get crushed. And so I still believe that in a downturn, direct lenders are better positioned, they're closer to the cash, they're closer to the information from the borrower, and they have strong relationships with PE shops, which helps significantly. So you always see solutions put in place way faster in the direct lending market than what you see in the BSL and high yield bond market. And that makes a huge difference. We saw it during covid o that helped borrowers whether tougher times. And lastly, like the long term locked up and sticky capital that direct lenders raise, it allows them to sit tight in weather. They don't get forced to sell assets and that makes a huge difference versus what you see in the liquid markets.
Speaker 1 00:16:57 Okay, great. So, uh, much to keep an eye on next year. So, uh, we'll stay tuned for all of that. Uh, Fran, thank you so much for sharing your insights with us and thank you all for tuning in. I invite you to check out our direct lending and BDC [email protected]
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