The above Twitter thread was promoted by well known hedge fund manager Boaz Weinstein, who I’ve written about prior. The major conclusion is that private credit is going to have its leverage pulled as a result of deteriorating portfolio metrics, and the result will be major dislocation. It got strong airplay, predictably, as Weinstein effectively vouched for the original poster as highly credible.
The following was my initial reaction (via Twitter), with further commentary following.
Everyone wants to paint private credit as a binary scenario. Certainly Boaz has an interest in doing so given the instruments he bets with. It’s also much more exciting to think about a replay of ’08.
In reality it’s likely shades of gray and less calamitous.
1) Everyone talks of defaults. But levered issuer earnings have gone up in ’22, and signs point to the same in 1Q. While interest is squeezing margins, absolute earnings dollars are up. Thus companies are *de-levering*. Doesn’t mean they have a hard time refinancing.
2) It’s shades of gray. There are some real garbage private credit lenders out there (in terms of quality), and some that care about not losing money. But all you see are top-line metrics that look the same on the back of low rates / defaults.
Things with giant asset managers on top tend to have shadow support from the manager – meaning their financials aren’t reflective of the financial support they have. There are many examples of support being extended in a quiet way.
3) It isn’t a one way street in which lenders get scared and pull lines. Often times, these warehouse lenders make their overall revenue lines in large part from fees derived from these same clients in other lines of business. So it isn’t all that simple.
I’ll finish my unorganized soap box with – the scary events happen where nobody is talking about, always. Things like private credit, lev loans, CLOs have been in BBG headlines at least every month as the next thing to blow. Just food for thought.
So that guy thinks that there may be a major dislocation in junk credit. But what of the equity that sits on top of it? I think people, lazily, have for the most part assumed that PE equity was trash to start with and is worth less than zero today. A few things…
Interest coverage. Interest coverage at PE companies is somewhere between 1.5-2 times on average, based on what middle market lenders report. That is down from near 3 times before interest rates rose, but still comfortably above 1x. So while there’s some smoke, there’s no fire.
Growth. PE owned companies are…growing. Private credit lenders often report portfolio company growth to gauge portfolio health. Midcap reported 1Q23 revenue growth at low double digits with EBITDA growth in the high single digits. So margins are shrinking but absolute profit dollars are rising. Diameter Capital wrote the following in their 3Q-22 letter [my edits]:
To start with some context, it’s helpful to consider the way that inflation has impacted earnings.
…Consider a business that in 2021 had $100 in revenue and $50 in variable costs. It was hit hard by inflation, with costs up 10% to $55. Revenues were up, but only by 6% to $106. The company’s profit margins were arithmetically down. It’s return on capital is also lower. But its earnings grew year-over-year by 2%.
This encapsulates the second quarter earnings that were delivered throughout the summer, as inflation yielded nominal earnings growth despite margin difficulties.
To get the kind of real capitulation that the bears have been waiting for, you need earnings to retreat, which only happens in recessions and hasn’t yet materialized.
Midcap’s CEO also commented in early 2022:
Just sort of at the risk of being a little back of the napkin here, but just generally to the market for us and other senior lenders, if you have a 5x senior loan, when LIBOR or SOFR was below 1, say our book had an average interest coverage, a senior interest coverage of 2-3x.
If those equivalent rates go up on a 500 overspread to 250-300, you’re going to move to 1.9 or 2x on average, apples to apples which no doubt (interrupted: probably that’s even the fixed charge coverage, so interest is even…) even more so, but that’s the quantum move which is not an irrelevent move, but obviously the other issues like you know, EBITDA getting compressed because of supply chain and inflation and labor costs, that’s a much more significant item.
The interest cost is just sort of like a cherry on top. So, like the performance of the companies is what matters a lot more. Again, it’s not irrelevant, but it’s just an input, and it’s not probably the most important input when you think about how all these floating rate portfolios – I mean obviously if [base] rates went up to 800 points, that would be differerent, but there would be a whole different set of reasons that that would occur. We are still in a historically low to moderate [range of] interest rates. I mean, it’s a long way from kind of where it was even 20 years ago, let alone the peak of 40 years ago. It started at zero. So yes, it’s still relatively low in terms of debt service costs, we’ll see what happens.
Today, the economy is strong. I think people hate to admit it, but cutting out speculation of the future state, all current numbers point to a tight labor market and economic growth. Specifically, UE is 3.4% and the Atlanta Fed is predicting 2Q23 GDP to clock in at 2.7%. In this frame it’s really hard to envision wholesale capitulation, especially in the debt, of said portfolio companies.
What would you guess a B+ rated company that is PE owned, net leverage of 5.5x, EBITDA of $1.7B and about $10B in debt outstanding would price $3.5B in loans and bonds in today’s sort of market? It’s an unfair question because that is not enough information.
Clarios is a Brookfield owned carve-out from Johnson Controls that sells car batteries for ICE and next generation vehicles. Last week it priced $2.75B in term loans at S+375 and senior secured bonds at 6.75%. All in pricing for the package was about 7%. Keep in mind for issuers in the $250M zip-code and below, loans are going out at around S+700 (perhaps B/B- issuers).
What does this mean? For me, it simply means that it’s difficult to paint an entire market with one brush. As mentioned before, it’s shades of gray. CCC debt is trading somewhere north of S+1000, in some cases far north of that. Until EBITDA turns materially negative across the board (a real recession), we’re just shaking out some players that happened to be swimming naked, not throwing out the proverbial babies with the bathwater. Clarios is case in point of great pricing for well situated junk issuers.
And in a market that is waiting for the most hotly anticipated recession in this generation’s memory, the current data are not pointing towards one that causes dislocation, liquidation, and associated deep distress. It may come, but in my opinion, the reason for such an event won’t be what is talked about today, and the epicenter won’t likely be near where most are watching.