Private equity is a huge global industry able to assemble vast financial power to acquire multi billion-dollar companies all over the world. The growth of this sector is on the back of delivering attractive returns to its investors and the industry’s ability to evolve its model in changing and demanding times. But for the astute investor there are more ways to benefit from investing in private companies, and at top of that list is private credit. This modest cousin of the private equity industry has just as good a track record, is more transparent, has a floating rate yield and typically delivers its returns in cash every quarter, and yet many investors have little or no exposure to it in their alternative asset allocations.
The investment grade corporate credit space is enormous and is well represented in most portfolios but private credit, which is typically non-investment grade (ie below BBB) is less appreciated, particularly here in Europe. The European market is €800 billion with approximately €140 billion of new issuance each year. These are loans and bonds that are issued by some of Europe’s largest private companies. At Spire we invest in loans and bonds in over 150 European companies where the average EBITDA is over €350 million. These are substantial, robust companies typically, but not exclusively, owned by a private equity house. All sectors are represented, and most are headquartered in Northern Europe. They issue the loans and bonds to fund a leveraged buyout or an expansion plan. These loans have proven to be extremely robust, with average default rates of circa two per cent since 2010 after averaging only six per cent 2007-2011 which were the dark days of the global financial crisis (GFC). This is no surprise given the scale of the underlying business and the support of a highly engaged shareholder. The loans also benefit from first ranking security over the assets of the borrowing company and as result when disaster does occur there is generally a good recovery of value for the loan holders. The long-term average recovery rate for senior secured loans is circa 75-80 per cent.
A substantial proportion of these loans are bought by CLOs, (Collateralised Loan Obligation). These are leveraged vehicles that build a highly diversified portfolio of
around 100 different loans and are typically about €400 million in size. The strength of the underlying issuing companies allied to the portfolio diversification means that these funds can comfortably cope with material leverage. In Europe, this approach has stood the test of time as even during the GFC all CLOs survived and some continued to make equity payments. Today average distributions are circa 14 per cent though some managers, including Spire, deliver closer to 20 per cent. On a risk adjusted basis, it is very attractive.
There is much talk at the moment about where we are in the credit cycle. It is always hard to say with any confidence but at present there is no sign in Europe of a downturn, defaults remain low and the performance of the underlying companies that issue these loans is generally healthy (bar a few exceptions). Most sectors are enjoying some stability with the possible exception of mainstream high street retail. In the US the situation is a little different. Here, there is a lot of concern about the quantum of BBB corporate loans and bonds which have seen massive issuance in recent years, currently there is $2.47 trillion of this US corporate debt. This does need to be carefully watched because of its sheer scale. BBB loans are investment grade but are the lowest rating that the traditional funds can hold. It does not take much underperformance in the underlying businesses to drive a re-rating at which point most of the existing holders of these assets will be forced to sell them because they will no longer be investment grade and therefore outside of their mandate. This could trigger a wholesale sell off with all the usual destabilising effects. So, US investors, the Fed and regulators are right to watch this space.
However, it is not so significant over here!In our arena of the non-investment grade credit, we do not face these pressures. The market is much more modest in scale at around 20 per cent of the US market, is broadly in balance and stable and does not face this type of potential structural shock. This market and the CLOs that invest in it have a good future so long as we maintain our focus on the credit quality of the underlying companies that we lend to.
European non-investment grade credit has delivered first class returns to its investors and there is no reason to suppose that it will not continue to do so. Most investors should take a good look at it.
