Private debt: is 2023 the best time to invest?

How are your portfolios faring in these uncertain times, and how are current conditions affecting the market?
Our portfolios are holding up well. That’s no surprise - we focus on industry-leading businesses that have strong and stable cash flows, with traditional financial covenants and tight structures, so our underwriting standards have historically been very high. Additionally, we’ve always avoided oil & gas and more cyclical industries. Our close attention to interest coverage ratios and building substantial cushion into our models has also paid off.

Regarding new deal activity, we are being even more conservative and cautious. Fundamentally great businesses can still be impacted by supply chain shortages and inflation, for example around their ability to pass on price increases. Nevertheless, the current deal environment remains active. With public and leveraged loan markets essentially closed for new issues, virtually all new financing activity has migrated to the private capital market.

Private equity sponsors, and businesses more broadly, are gravitating toward private credit solutions, and particularly to the largest, most scaled managers. The deals coming to market are generally higher-quality businesses whose operating models arm them to battle supply-chain issues and inflation more successfully. Private equity firms with businesses that are negatively impacted by the current environment are generally not transacting. 

How are volatility and the limited availability of capital in the public credit markets driving activity for private debt managers? 
With public credit markets essentially shut down right now, private debt managers with scale and deep relationships are taking share. Historically, if you had a loan issue size of over $300mn or $400mn, the deal would be completed in the liquid markets. Today, a company with $100mn or more in EBITDA only has one option – the private debt market. We are generally seeing larger, more established companies tapping the private markets, resulting in a significant uptick in our volumes.  

That said, size and scale is a key differentiator for direct lenders today. There are only 10-15 firms in the market that have the balance sheet strength to underwrite $400-500mn on a consistent basis. These firms are benefiting most from the current landscape.  

Private credit surpassed $1tn of AUM at the start of 2022. Will the growth of private debt continue long term?
We have continued to see tremendous growth in private debt over the last year, largely at the expense of banks that have moved to distributing large-scale liquid credit. Scaled and differentiated private debt managers continue to raise significant capital, as investors seek less correlated and more diversified sources of steady income. In addition, there have been huge amounts of capital raised though retail and wealth channels, creating further avenues for industry growth. The ‘democratization of private debt’ trend is certainly here to stay.  

Direct lending has been seen as overcrowded in the past, but now the sentiment has shifted. What’s changed? 
Industry participants are no longer questioning if the market is overcrowded. The Fed’s actions are drying up capital across many asset classes and the denominator effect is having real implications for investors. In addition to market uncertainty, these factors have made dry powder extremely valuable right now. Because of their strong level of deal flow, leading managers with available capital can afford to be extremely selective. Few firms have the scale, the relationships, and the track record of delivering for their private equity clients to compete effectively for the most attractive deals today. If anything, the direct lending market is consolidating.  

Top direct lenders are being prudent about investing in the current environment, thanks to greater risk and an increased focus on diversification. Diversification has always been a cornerstone of our investment philosophy, and we’ve historically had an average position size across our various vehicles of no more than 1-2%.  

I believe the current credit environment will shake out some of the second- or third-tier players, increasing the value and importance of dry powder, scale, and relationships. At Churchill, we have over $8bn of dry powder, which is a clear competitive strength today. It allows us to fully participate in one of the most attractive investment environments in recent history.

What are you currently observing in terms of origination trends, pricing, leverage, and deal terms?
The current dynamics have enabled large-scale managers like Churchill to benefit from more attractive deal pricing and lender-friendly terms. Compared to a year ago, pricing has increased as much as 50 to 100 basis points, with better origination or upfront fees, for conservatively structured senior secured loans. Higher interest costs are driving lower leverage. Attachment points today are a turn lower from a year ago. A key investment indicator is all-in yield per unit of leverage, which is up 30-40%.  

We continue to focus on companies benefiting from the shift in personal and business behavior in the post-COVID world – logistics, software, and healthcare – avoiding sectors impacted by rising rates. Given where rates and returns are today, there is no need to capture higher yield by taking on higher risk.

What are the attractions of private debt for investors now?
We believe 10%+ yields are achievable for conservatively structured senior secured loans with leading private equity sponsors who are contributing significant equity to our transactions. High quality businesses, floating rate returns (defensive relative to a rising-rate environment), excellent loan-to-value, strong financial covenants, and top-tier private equity ownership all point to a very constructive world for private credit managers.  

Public market volatility and uncertainty have also reinforced the virtues of private debt for many institutions. The asset class is much less correlated to headline risks and offers a diversified source of income and total return potential, along with interest rate protection. Private debt is very well suited for today’s investing landscape.

What is the outlook for private debt fundraising?
Interestingly, the best time to invest is often the most challenging time to fundraise. Given the rebalancing that’s occurring in many institutional portfolios, we think that 2023 will be a more challenging fundraising environment than 2022 was. However, we continue to expect strong demand for top managers that have scale, unique competitive advantages, and proven track records. In October, we announced that our latest senior lending program raised approximately $12bn from more than 150 investors globally.

Going forward, we believe investors will increasingly differentiate among managers and strategies based on the market segment they focus on. Senior lending strategies will continue to be favored, with a focus on more conservative managers in the current environment.  

What changes do you expect to see in the private debt market over the next five years?
First, the traditional middle market and increasingly larger companies will continue to transition to direct lenders away from banks as capital providers. Speed, certainty, confidentiality, and the ability of certain lenders to underwrite sizable financing solutions across the capital structure will continue to drive market share for private debt relative to the syndicated markets.  

Second, the market will continue to specialize, as top managers gain share at the expense of smaller players. I expect we will see fewer large-scale firms capturing the lion’s share of the most attractive traditional direct lending transactions. Simultaneously, other managers will specialize and control other areas of the market, such as distressed, non-sponsored, lower middle market, and so on.  

Finally, the private debt industry’s investor base will continue to broaden. Ten years ago, for instance, we would meet with institutions, and any private credit allocations would be coming from their private equity or mezzanine sleeves. Today, most large institutional investors we speak with have a dedicated private credit allocation. On top of that, the growth in individual investors participating in the market is still in its relatively early days. 

About
Ken Kencel serves as President and CEO of Churchill Asset Management, an affiliate of Nuveen, the asset management arm of TIAA, a Fortune 100 financial services company. He also serves as Chairman of the Board, President and CEO of Nuveen Churchill Direct Lending, Inc., Churchill’s publicly registered business development company.  

Churchill manages over $41bn (as of September 30, 2022) in committed capital, and focuses on providing senior, unitranche, and junior debt financing, and making equity co-investments and fund commitments to leading private equity investment firms and their portfolio companies. Churchill is among the most active private credit managers in the US, annually investing more than $14bn in over 450 middle-market companies.