Major U.S. stock indexes have fallen double-digits year-to-date, pushed lower by a combination of rising inflation, Federal Reserve rate hikes, supply constraints and geopolitical disruptions such as than the war in Ukraine. Pitchbook analysts say there’s a 20% chance of a recession in the next 18 months.
These dynamics, along with the Fed’s shift in approach to monetary policy, are driving down valuations among venture capital-backed companies and changing the calculations around leverage and valuations in deal deals. redemption.
Against this backdrop, we spoke with Randy Schwimmer, co-head of senior lending at Churchill Asset Management, the $30 billion direct lending arm of Nuveen. His team provides a combination of debt financing to middle market companies in the form of first lien, unitranche, second lien and mezzanine debt.
Schwimmer shared his outlook on economic conditions and how he expects private debt to perform during the ongoing turmoil in financial markets. He also described how he learned to live with and profit from inflation fears.
PitchBook: The Fed raised its benchmark interest rate in early May, the final step in tackling a 40-year peak in inflation. However, stock markets fell in the following days. What is the market worried about?
Schwimmer: We expected 2022 to be a quieter year than 2021. We thought the market priced in rate hikes on the expectation that the fed funds rate would hit around 3% by the end of 2022. And the Markets believe the Fed will pull off a soft landing that hopefully won’t result in a recession, as the Fed appears to be stepping in at a measured, albeit potentially accelerated, pace. Then the Ukrainian war moved [the market] into a new gear of higher volatility, as well as an increased level of concern about some measures of inflation, particularly food and energy prices, which has raised concerns about the pace of inflation. global inflation.
The markets’ concern now is whether the Fed can catch up? Or will they have to rush to catch up, which means they could tip it all into a recession – that’s what you’ve seen [with the stock market decline] Last week. What changed and led to Friday’s downfall?
Now, the conversation about a potential recession – which I think is still a minority view – has tilted investor sentiment to be more pessimistic than deserved.
We are in a period of uncertainty, even if consumers continue to spend and there seems to be a real dynamism in the economy. We see this short-term volatility, which is obviously somewhat concerning.
PitchBook: Looking ahead, how will private credit as an asset class fare in the year amid uncertainty about the broader economic backdrop?
Schwimmer: The interesting thing about private capital is that this period, characterized by rising rates and increased volatility, is when we normally shine. The normal diversified portfolio which is based on a mix of public equities and fixed income securities increasingly includes an alternative bucket – not just private credit, but also real estate, private equity, agriculture, infrastructure and all other assets that are less correlated to liquid assets. trading on overall risk.
Most investors have been thinking about alternative assets for a decade, more intensely in the past two years, especially after the emergence of the COVID pandemic. Now, with the volatility triggered by the war in Ukraine, investors are concluding that alternatives are a good place to be, as they will earn relatively higher returns than liquid assets, with lower volatility and less correlation to risk. global.
The question today is if we expect a potential recession and much higher interest rates and inflation, does that change people’s view of private credit? We conducted a survey of 62 institutional investors, which shows that LPs have increased their appetite for private debt and private capital as a result of what is happening.
The 10-year US Treasury yield is around 3% and the fed funds rate is 1%, which will continue to rise. Now we have to prove that private credit will generate a relatively higher return, even with the risk-free rate[10-year US Treasury yield]reaching up to 3% by the end of next year. Yields on unleveraged senior debt in direct lending are currently around 6-7%. If SOFR, which is just above 1% (and regularly replacing LIBOR as the benchmark for direct lending), rises to 3%, that’s a significant extra return, even if spreads compress over time.
Pitchbook: Are you concerned about a possible recession? How should private debt investors be prepared for this?
Schwimmer: We are not afraid of a recession. In fact, recessions have been good for private debt because they tend to push back some of the borrower-friendly conditions that may not benefit investors. For example, covenant-light in the middle market, which in our opinion is not the best idea for this traditional middle market of companies with less than $50 million in EBITDA. The middle market is different from the syndicated loan market or the high yield bond market – where issuers are rated and a liquid secondary market exists to allow managers to trade at the first sign of trouble. Middle market loans do not trade. Managers “own” the position, so the covenants play a crucial “early warning” signal if performance deteriorates. A recession could wipe out the riskiest [from an investor’s point of view] structures apart.
It is also historically true that financing terms tilt in favor of the direct lender in times of financial crisis. Spreads increase, leverage decreases, structures tighten. The other thing a recession could do is [create an environment in which] only direct lenders with strong portfolio performance and significant capital to deploy are going to be active, this is what we saw in the first quarter of 2020. In the early summer of 2020, Churchill was lending without much competition. I think all of these things could happen again in a recession.
In our view, a recession, which could be on the horizon next year or anytime, will likely be moderate because the Fed has a very dovish response to illiquidity. If there is a recession, it will be short-lived. The Fed tends to flood the market with a lot of liquidity and we think it would do it again.
We are also less concerned about rising interest charges from corporate borrowers. For one thing, we include the forward yield curve in all of our projected debt service models. In addition, a SOFR level of 3% is well below the LIBOR of 5.5% achieved in 2007. Finally, the companies we finance have high free cash flow characteristics which enable them to amortize the additional fixed costs well. . If there is no satisfactory cushion, we will forward the case.
But I believe with companies that are on the bubble, that don’t have free cash flow, that are in less defensive and more consumer-facing sectors such as retail, premium brands , housing, and now food, and companies that are not market leaders, you will see some pressure on interest, expense coverage, and fixed costs.
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