How two private credit pros assess the new landscape

With so much turmoil in the world today, we checked in with two pros from the realm of private credit who can help us better understand the changing macro environment, and how they’re adapting to it. We turned to PineBridge Investments’ Private Credit team: Joseph Taylor, Head of Capital Markets, and Doug Lyons, Head of Origination. PineBridge is an institutional asset manager with approximately $141bn in AUM, and the Private Credit team focuses on direct lending to businesses in the lower middle-market, with an average entry-level EBITDA of around $20mn.

Having managed the COVID-19 crisis of 2020, how do you anticipate weathering current challenges?
Taylor: While today’s macroeconomic environment is in some ways unprecedented, we’ve weathered similar cycles before. Global inflation figures are at the highest in decades, and central banks are reacting quickly and aggressively by hiking base interest rates. While the ongoing recovery from the COVID-19 pandemic indeed plays a continued role in current high inflation and sustained supply chain stresses, Russia’s war against Ukraine has also contributed, impacting food and energy prices. So, after a year characterized by economic recovery, we’ll likely face more complex questions in the years to come with many forecasters seeing a recession as the next stop on this train.

This one will be unlike what we saw in 2020, however. At the onset of COVID-19, central banks addressed it with accommodative policies that helped backstop companies by setting an artificial floor that won’t be there this time. Weak companies going into the next crisis won’t find this same liquidity and may have to restructure. Furthermore, lenders won’t be able to provide additional liquidity, meaning resilience and industry experience will play a larger role. 

What positive developments came out of the previous crisis for private credit?
Lyons: COVID-related challenges created an opportunity for some equity sponsors and companies to stand out by adapting on the fly. Many are now stronger for it; the changes made – such as transitioning marketing and sales efforts to online and direct-to-consumer channels – helped them survive this unexpected situation. Internally, changes in staffing and product lines, and implementing remote-work technologies, further strengthened them.

Which areas of private credit do you anticipate maintaining liquidity through the next downturn?
Taylor: Cash is king and will help companies weather the storm of inflation, higher interest rates, and slower economic growth. We believe the lower middle-market will come out ahead of larger peers. This segment’s leverage is based more on free cash flows and less on enterprise values, giving these companies more cash on hand and ultimately the lower middle-market is less likely to face a liquidity crisis. Lenders tend to pay higher multiples for these businesses, which often have strong private equity support if the equity backers will look to protect that equity. 

The current environment will eventually lead to higher defaults and other unseen challenges. That said, the lower-middle-market segment is likely to weather this environment more seamlessly compared with other areas of credit. The lower middle-market has historically experienced very low levels of realized losses – due to fewer EBITDA adjustments at underwriting, lower entry leverage points, financial covenants to detect performance deterioration, and efficient, nimble lending groups (Fig.1).

Through all of this, manager selection is crucial. The ability for direct lenders to handle workouts or distressed situations will be key to determining outcomes. Further, excessive leverage will be a limiting factor for providing additional liquidity in times of distress. Ultimately, direct lenders don’t want to strike out and will protect the downside. It’s far more difficult for a debt platform to recover from a loss compared with equity, and in down markets, they’ll look for adequate cushion and liquidity to keep the company afloat during stress.

Is the illiquidity premium shrinking relative to public credit markets, and if so, why invest in private credit now?
Taylor: Low base interest rates and market competition have many investors asking if yields are in parity, or are private credit yields approaching their public market counterparts? While these concerns have some validity, they ignore private credit’s durability and consistency, limited volatility, and resilience in choppy markets. Moreover, while this illiquidity premium against syndicated loans has temporarily contracted, history has shown that over time, the premium is sustained, generally around 150 to 200bps (Fig. 2). 

Will your investment approach change?
Lyons: No, we are not implementing any changes to our investment approach or due diligence process. Our process is designed to help make decisions on how various industry and market factors could impact an investment. We will continue to perform an ODD (operational due diligence) into a company’s operations, prospects, management team, and cash flow, as well as other crucial items to a company’s success. Key questions we’re asking now are: Will the company’s cost structure provide flexibility in a downturn? Can the company pass along price increases to its customers if its own underlying costs continue to increase? Pre-COVID, people would likely say one of the strengths of our market is that the companies we invest in have validated enterprise values (EV). This EV provides a measurable equity cushion between the debt and equity. But in today's environment, we're a little more focused on fundamental cash flows, because despite EV, you may need to maneuver through challenges on a real-time basis.

In private credit, you can’t quickly sell a position because you don't like what's occurring or how companies’ dynamics are changing. Accordingly, we believe private credit portfolios should be built based on conservative risk-adjusted returns, focused on the downside and with emphasis on diversification of investments, industries, and sponsors. That’s part of how we think about portfolio construction across the board. If you have a 200-basis-point increase in the underlying rate, what does that do to your overall portfolio? Fixed-charge coverage ratios and interest coverage ratios are all paramount in our analysis. We haven't seen spread compression yet, but we can't tell you it's not going to happen. And in these kinds of economic times, better credits have performed quite well. All told, we believe it’s important to stick to your strategy and avoid style drift. In our view, changing one’s fundamental investment approach or overall philosophy with each shift in the tide generally doesn’t lead to positive outcomes. Time-tested strategies with a core, unwavering investment thesis are what tend to perform better across cycles.

About
Mr. Taylor joined PineBridge in 2017 and leads the team's capital markets efforts. Mr. Taylor has over 30 years of banking and lending experience, including middle market direct lending, capital markets and CLO asset management. Prior to joining PineBridge, he was a senior origination team member and Head of Capital Markets at Business Development Corp of America.

Mr. Taylor received a Bachelor of Science in Finance from the University of Scranton and a Masters of Business Administration from the Stern School of Business, New York University. Mr. Taylor is also a CFA charterholder. Mr. Lyons joined PineBridge in 2017 and leads the team's origination efforts.

Mr. Lyons has over 25 years of financial advisory and service experience, inclusive of middle-market direct lending, investment banking, and public accounting. Prior to joining PineBridge, Mr. Lyons was a senior origination team member and Head of Origination at Business Development Corporation of America, where he was hired as a founding team member in 2013, alongside Mr. Taylor.

Mr. Lyons received a Bachelor of Science in Accounting from the University of Southern California and an MBA from the University of California Los Angeles.