SCIO, a lender specialising in European asset-based credit, focuses on providing long-term value to investors and borrowers alike. Partner & CIO Greg Branch chats to Private Equity Wire about some of the current challenges and opportunities in the space and the outlook for special situations and asset-based finance.
How are current economic conditions affecting the private credit market?
Banks often struggle when interest rates spike. Not convinced? Ask shareholders in Silicon Valley Bank and Credit Suisse, they know. Banks have thus retrenched amid liquidity constraints and higher costs related to over-regulation. This is especially true in Europe, with 73% of European banks now trading below book value (source: BCG). This has forced banks to tighten lending standards, creating a funding gap.
Private credit has stepped in to fill this demand. Bolstered by strong returns, allocations to private debt grew 29% in 2022 (source: McKinsey & Co). From a performance perspective we expect the next few years will be the best vintages for private credit investors since the GFC.
Is default risk on the rise due to inflation and recessionary pressures?
Yes. Current economic conditions are weighing on public and private credit alike. Commercial office real estate, subprime consumer debt and overleveraged corporate borrowers have all been pummeled by the rapid rise in interest rates. Making matters worse, rates are priced to remain elevated for some time. Overleveraged borrowers or those forced to refinance existing debt will struggle to survive.
That said, private credit is set to outperform vs public credit for a variety of reasons.
For public corporate credit, years of easy money led to weak underwriting standards. This is now giving rise to lender recovery rates a fraction of historical levels. Over the past year, JPMorgan observed that high-yield bond recoveries were only 19.6%. This is a mere fraction of the 25-year average of 40.2%. Private corporate credit, in contrast, feature tighter loan covenants.
Private credit is also bilateral in nature. Why is this important? Because fewer parties mean more room for a negotiated resolution of problem credit than with syndicated public debt. Taken together, this should result in higher recoveries vs public debt.
The outlook is even more positive for asset-based finance. The sector benefits from diverse pools of assets. Assets which generate predictable, recurring cash flow streams. These assets often have floating coupons that benefit lenders during periods of higher rates. Furthermore, higher rates of inflation increase the nominal value of assets, providing additional support.
What emerging opportunities do you see for private credit firms in the near future?
We see compelling opportunities across a wide range of private credit strategies.
Asset-based private lending, SCIO’s area of focus, looks especially compelling. This is owing to the loan’s collateralised nature. During periods of economic weakness, the loans perform better than loans to corporates. This sector also enjoys less competition and less dry powder overhang.
Distressed debt is also set to outperform. Corporate defaults are rising owing to higher-for-longer interest rates. Yet will growth in the opportunity set be able to match the massive amount of dry powder currently allocated to this strategy? According to Preqin, private credit funds have more than $400bn of dry powder as of September 2023. Only time will tell.
Direct lending, the largest sector, will experience mixed results. Legacy portfolios will struggle as higher interest rates take a toll on borrowers. New origination, in contrast, will be underwritten taking current economic challenges into account.
Greg Branch, Partner & CIO, SCIO Capital – Prior to founding SCIO in 2009, Greg was at Deutsche Bank AG London where he headed up the European ABS/CDO trading desk after joining in 2000 as Director and Head of Analytics for the Structured Products Group in Europe. Greg joined Deutsche Bank from Lehman Brothers in New York, where he headed the Commercial Mortgage Analytics group. Greg holds a Master’s Degree from Carnegie Mellon University and a degree in Aerospace Engineering from the University of Notre Dame.Â
