Is private credit a bubble?
Relevant for: Leveraged loans, CLO BBs, and CLO Equity
We do not believe private credit is a bubble. As a result of Federal Reserve interest rate hikes, middle market loans yields are now in the low double-digits. In the typical corporate capital structure, the more risk you take, the higher the required return. However, middle market loans could offer returns well in excess of where many economists project long-term equity returns to be. Middle market loans are senior and secured and therefore typically offer more downside protection than high yield bonds or equities. Standard and Poor’s estimates that private equity firms have raised $2.5 trillion that has yet to be deployed.1 We believe much of that capital will be used to buy middle market businesses in transactions where the loan will make up less than 50% of the purchase price. A substantial equity contribution from a private equity sponsor provides downside protection for the middle market loan investor. This favorable risk / return dynamic for middle market loans hasn’t existed for the last fifteen years, in our opinion.
Middle market loans are owned in long-term non-mark-to-market funds. The market should not see any forced selling of middle market loans due to margin calls. The result is more stable loan pricing over time.
Middle market lending has never been a zero-loss investment opportunity. Unforeseen events can push some business into default. When we model CLOs, we include a 60bps loss rate on the loans, consistent with the historical loss rate in those portfolios. Prior to the increase in interest rates, we believe most middle market loans were paying a fixed spread of approximately 5.0% over a LIBOR floor of 1.0%. Now, middle market loans pay the spread over the Secured Overnight Funding Rate (SOFR), which finished the year at 5.3%. The additional yield of 4.3% could provide an attractive offset for any increase in loan losses that could result from a slowing economy.
Outside of traditional middle market lending, we see risk in broadly syndicated loans where the loan documentation did not adequately protect creditors’ rights. We also see risk in second lien loans and unsecured debt, where if the loans were to default, recoveries would be much lower than first lien loans.
Can borrowers afford higher interest rates?
Relevant for: Leveraged loans, CLO BBs, and CLO Equity
Higher interest rates have resulted in less cash flow for middle market businesses, but that has been partially offset by the borrowers growing revenue and profitability. At the end of the day, corporate borrowers either make their contractual interest and principal payments, or the lenders take over the business and work for the best loan recovery possible. Given the average initial loan-to-value for senior secured loans is around 50%, there is significant equity and junior capital financing each borrower. We believe that the private equity firms would rather support their existing portfolio companies for what is expected to be another year or two of higher rates, rather than take a total loss on their equity investment. Higher interest rates have resulted in a favorable shift in economics away from private equity for the benefit of senior secured lenders.
Where we’ve seen borrowers struggle, the cause is usually some input cost pressures that can’t be passed along to customers or the loss of key customers to competitors. If the business is tracking to plan, the higher rates are manageable, in our opinion.
The SOFR forward curve predicts that SOFR will decline by 2.5% over the next two years,3 increasing borrower cash flow and liquidity. Of course, higher for longer has been a smart wager.
When / if refis and CLO extensions will be possible?
Relevant for: CLO Equity
In addition, many CLOs issued in 2022 and 2023 have elevated debt costs, relative to current levels. Many of these CLOs are good candidates to extend their reinvestment periods, even if CLO AAA spreads do not decline further.
CLOs issued in 2021 or before, may go their full lives without refinancing their debt or extending their reinvestment periods. In such cases, the CLO equity could benefit from below market financing costs for the CLO’s 8-10 year expected life.
A CLO reinvestment period extension has the potential to add 2% to our base-case projected returns, assuming no change in the CLO’s cost of debt. The value of refinancing portions of the CLO’s debt at lower rates depends on the magnitude of the cost reduction. A general rule is that 10bps of reduction in the CLO’s cost of debt results in 80bps of incremental cash flow to the CLO equity for a middle market CLO levered 8.0x.
What are the causes and effects of lower loan issuance?
Relevant for: Leveraged loans, CLO BBs, and CLO Equity
Much of primary activity in the loan market this past year resulted from refinancings, repricings and maturity extensions, rather than new LBOs. While new loan creation was down, the quality of new loans that did come to market was high, in our opinion, both in terms of the projected returns of new loans as well as lender-favorable documentation terms.
The decline in new loan activity resulted in stronger bids for higher quality credits in the secondary market. During 2023, the Morningstar Loan Index (“the Loan Index”) increased from 92 to 96. Higher loan prices were a tailwind for CLO equity and CLO BB returns during the year.
Has there been CLO self-healing over the last two years?
Relevant for: CLO BBs and CLO Equity
The Loan Index ended 2021 at 99, but during the last two years, the Loan Index had an average price of 95.5 This has provided an opportunity for CLOs to buy discounted loans. However, the loans that CLOs invest in tend to be more conservative than the overall Loan Index. We believe that our CLO managers have been able to invest loan repayments at dollar prices between 97-98 throughout the year. This is accretive to CLO equity returns given our usual CLO modeling assumption of a purchase price of 99.
Is there a trend towards lower loan recoveries in the event of default?
Relevant for: Leveraged loans, CLO BBs, and CLO Equity
For broadly syndicated loans, recovery rates for 2023 were poor, which was a headwind for CLO equity returns. Fortunately, loans default rarely, and the default rate of 2.0% at year-end 2023 was consistent with our modeling assumptions.6 But across the 52 defaults in 2023 tracked by JP Morgan in the syndicated loan market, the recovery rate was 36.4%.
There are two primary reasons why broadly syndicated loan recoveries have been coming in below our typical CLO modeling assumption of 70%:
1. Initial loan to value was marginally higher than in the past, i.e., less equity and unsecured bonds as a % of the initial financing
2. Loose loan documentation did not adequately protect creditors’ rights
While JP Morgan measures the recovery rate of a loan as the trading price 30 days after the loan defaults, that is not the ultimate recovery value. In a default, the lender often ends up with a restructured term loan and an equity investment. In some cases, the equity upside can be substantial, but it takes time for the recovery to play out.
We view low loan recoveries as unique to the broadly syndicated loan market. In the middle market, we believe loan documentation is still creditor friendly, and initial loan-to-values are below 50%.
We expect the impact of loan defaults to be less pronounced on CLO portfolios than on the loan market overall. CLO managers are actively managing their CLO’s underlying loan portfolios to improve average credit quality and ensure the CLO’s compliance with its many tests. Accordingly, CLOs own loans that are much more conservative than the overall Loan Index.
The other important variables that determine CLO equity returns have been tracking favorably: default rate, interest rate, new loan purchase price, and new loan spread. Additional CLO equity upside could exist in 2024 and beyond if we’re able to refinance our CLO’s debt at lower rates or extend their reinvestment periods.
1) S&P Global Market Intelligence, December 2023
2) Flat Rock Global Assumptions, for a borrower levered at 4.5x EBITDA paying a SOFR + 5% interest rate
3) Chicago Mercantile Exchange SOFR Futures
4) JP Morgan CLOIE Index
5) Bloomberg, LLC
6) JP Morgan Default Monitor December 2023
DISCLOSURES
Past performance is not indicative of future results.
This is not an invitation to make any investment or purchase shares in any fund and is intended for informational purposes only. Nothing contained herein constitutes investment, legal, tax or other advice, nor is it to be relied on in making an investment or other decision. Nothing herein should be construed as a solicitation, offer or recommendation to acquire or dispose of any investment, or to engage in any other transaction.
For further information feel free to email info@flatrockglobal.com
