Regaining Balance: Navigating Uncertainty in Private Credit Investing

May 2023

Continued macro-economic uncertainty is allowing lenders to get some balance back in their favour, as the borrower-friendly conditions of the past five years have receded, says Challenger’s Sid Kumar.

Kumar says rising interest rates, tightening liquidity and concerns about the potential for a global economic downturn have to some extent reduced competition for lending and increased caution in lending practices. Counterbalancing this somewhat is patchy deal flow and M&A headwinds, which means buyside money is chasing fewer deals. On balance however, things have moved in favour of lenders over the last 12 months.

“It’s opportune for lenders to get some of the balance back their way especially with documentation terms and pricing after four or five years of cheap money and loose term sheets chasing borrowers,” says Kumar, who heads acquisition finance at Challenger Investment Management.

Stricter loan requirements can provide greater protection against potential defaults and losses and allow lenders to better understand the financial situation of borrowers to assess risks.

Kumar says some changes coming back to loan documents include stepping down covenants that require borrowers to reduce leverage over the course of a loan, tighter financial definitions that drive covenants, better information disclosure requirements and flat interest margins that remain fixed regardless of borrower leverage.

The slowing market means investors seeking exposure to credit could look to deploy funds to the larger, more established providers in the market to ensure continued access to lending opportunities.

“The incumbent managers with sizeable existing portfolios benefit in times like this because they have a platform from which to deploy when performing portfolio businesses raise money for refinancing, capex or bolt on acquisitions. Incumbents don’t feel as pressured to stretch themselves on risk terms to win new deals to grow their portfolios, and this leads to better investment outcomes in the long run.”

Kumar says in a typical year, his portfolio would see about 20 per cent repaid as businesses go public, sell to other companies or outperform and refinance with cheaper bank debt.

“So that’s 20 per cent we will not lose this year because IPO markets have been cold, M&A is patchy, and finance is dearer.

Kumar says the team has been shaping the portfolio to prepare for a potential downturn in economic conditions as the pandemic stimulus wound down and the hawkish rates outlook emerged.

“This process started early in the last three years of deployment, ensuring that discretionary and consumer-facing borrowers have strong capitalisation and were leveraged modestly.

“The businesses that are somewhat leveraged in our portfolio are businesses whose products and services are not discretionary – they are defensive, mostly business-facing, of sizeable scale and able to pass on cost increases like higher wages to their underlying customers.

So, how can investors prepare their own portfolios for the risk of macroeconomic uncertainty?

Kumar says the key is selecting managers that have a track record of managing through a downturn.

“Challenger has been doing this since 2004. We’re the only private credit manager of scale that has investing experience through the GFC, mining booms, busts and COVID. We’ve invested in several hundred Australian private credit deals through the cycle” he says.

Linked to longevity is the ability to get deals and deploy at scale while being able to deliver on time and in line with expectations.

“That is possible because we can be of scale, bringing sizeable tickets into private credit deals. Also helps that we are headquartered here, so our decision makers appreciate local nuances of Australian credit investing. Borrowers appreciate reliability, so this is critical as it helps us say what we do and do what we say.”

Kumar also advises investors to perform due diligence on who is overseeing credit risk at the managers they are considering.

“An independent credit risk team is a very under-appreciated benefit and advantage. It works like a credit function at a bank but is more nimble than a large bank which may have rigid credit policies. This helps us deliver flexible solutions to borrowers while still managing sensible risk parameters on our investments.”