Ep. 48 The Long-Short | Giving private credit a health check, with KKR and Allen & Overy

Published: 30 November 2022

The Long-Short is a podcast by the Alternative Investment Management Association, focusing on the very latest insights on the alternative investment industry.

Each episode will examine topical areas of interest from across the alternative investment universe with news, views and analysis delivered by AIMA’s global team, as well as a host of industry experts.

This week, The Long-Short checks in on private credit markets to mark the launch of the annual ‘Financing the Economy’ paper by AIMA’s Alternative Credit Council and Allen & Overy. To help us unpack the main findings and provide additional colour, we’ve enlisted the help of three guests who were integral to the production of the report. Allen & Overy’s Denise Gibson, Co-Head of leveraged finance, and Hannah Gates, Partner in the leveraged finance team specialising in private credit, join us alongside Michael Small, Partner in credit and markets at KKR.

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Read the transcript 

Hosts: Tom Kehoe, AIMA; Drew Nicol, AIMA

Guests: Hannah Gates, Partner in the leveraged finance team specialising in private credit at Allen & Overy, Denise Gibson, Co-Head of leveraged Finance at Allen & Overy, Michael Small, Partner in credit and markets at KKR


Tom Kehoe, AIMA  00:02

Hello and welcome to The Long-Short, I'm Tom Kehoe.

Drew Nicol, AIMA  00:05

And I'm Drew Nicol. We have a jam-packed episode this week with three excellent guests here to talk about an area of the alternative space that we haven't covered in a while.

Tom Kehoe, AIMA  00:14

That's right, Drew. Every year since 2015, AIMA’s private credit affiliate, the Alternative Credit Council, has produced an annual report on the health of the private credit industry, tracking its growth and increasing sophistication. This year's report has just gone live and it's full of really interesting data points on how the private credit space has fared in a very different macroeconomic landscape it finds itself in today, compared to last year.

Drew Nicol, AIMA  00:38

The report is now live. But if you can't wait, then we're here to help you unpack some of the main findings of the report. And we have three guests representing members that were integral to the report production.

Tom Kehoe, AIMA  00:54

Later in the episode, we will be speaking with Michael Small, a partner in credit and markets at KKR, a multibillion-dollar global investment firm that offers alternative asset management as well as capital markets and insurance solutions.

Drew Nicol, AIMA  01:08

But before then, we're joined by Denise Gibson, co-head of leveraged finance at the international law firm Allen and Overy and Hannah Gates, who is a partner in the leveraged finance team specialising in private credit. You are both very welcome to The Long Short.

Hannah Gates, Partner at Allen & Overy  01:21

Thank you. Good to be here.

Drew Nicol, AIMA  01:22

So, I'm not sure which one of you wants to take this first, but just at a very high level, the private credit market appears to have been doing well recently. And I think it's fair to say there's a somewhat strong sentiment that it will continue to do so. It'd be really helpful if we could just start by laying out some of the drivers behind this growth, and maybe even just go back to the first principles and talk about some of the benefits of private credit for borrowers, as opposed to syndicated loans or even traditional financing sources.

Hannah Gates, Partner at Allen & Overy  01:52

Why don't I start by taking that question from the investor side, and then pass it over to Denise to maybe talk a bit more about the borrower perspective, if that sounds good?

So, there are a lot of factors contributing to the rapid expansion of private credit, both in terms of where primary investors choose to put their money, and also from the borrower perspective. On the investor side, we know from our clients that investors are attracted to private credit as an asset class because of the returns, because the investments tend to be more attuned to the stability of the underlying credit, rather than the market sentiment. And particularly because of the ability to still achieve portfolio diversification, while simultaneously having greater control over the ultimate investment, particularly, you know, with the right wide range of funds that they're able to choose between in terms of you know, setting their own agenda for size, sector jurisdiction of investment, as well as other criteria like ESG, and your multi-strat funds, which have more or less bandwidth for managers to decide where to deploy their capital. So, there's a huge range of products that investors are able to choose between and with the increasing range of products, we've seen a correlating increase in appetite.

Denise Gibson, Partner at Allen & Overy  03:07

Okay, I guess after everybody hasn't invested all that money, how do you go about deploying those funds? I think what has been increasingly interesting over the last few years is the expanded scope of borrowers who are really looking to private credit as an answer to their financing needs. And if I think that even sort of four years ago, speaking to one of the contacts at a key sponsor client, you know, they were not actually using private credit at all, I was still very much into the public markets, high-yield bonds, you know, and the syndicated TLB market. And if I fast forward that same sponsor to this year, well, in fact, not even just this year, because this year has been bespoke for a number of reasons, but private credit has become at least probably 50%, of what they do in terms of their financing needs. And for 2022, it's no surprise to anybody that this year, private credit has completely exploded, because actually, the syndicated markets have largely been closed. And so actually, you know, again, the growth this year has been phenomenal.

But as I say, this is not a trend that's just been caused by the syndicated markets being closed. I think there's been a year-on-year trend of more and more borrowers, looking to private credit for the solutions, and that's also because of the development of private credit, which I think we'll come on to talk about later today. But you know, this has been about the moving up the space from lower mid-cap into sort of upper mid-cap, and even now being able to really sort of compete with the underwritten market for some of the larger cap transactions. And if we think about what's been driving that trend, I think there's a number of things but one is that actually, I think people really enjoy the fact this is quite relationship-based lending. So, once you've developed a good relationship with one of the private credit institutions, you know, these people are going to turn up and they invest in your portfolio company. They actually want to act as a partner, they want to see the ongoing success because their interests are very aligned with the sponsors in terms of, you know, what is going to make this work in the longer term.

If we think about the COVID pandemic, for example, I think a lot of sponsors were impressed by what they actually got back from a lot of their private credit relationships in the sense of supporting those portfolio businesses because they could see that this was a short-term blip, ultimately if they worked together, that there would be a happy ever after for everybody. So, I think that has been really good, I think, COVID in a way, as has almost even cemented how useful this relationship side of the lending, private credit business can be.

Hannah Gates, Partner at Allen & Overy  05:46

Yeah, I absolutely agree with that. And I think, you know, one thing we saw, in particular, was that some sponsors, who maybe had a historic aversion to private credit, because they were worried that the tighter terms and the consequential ability to trip those up during a crisis, would cause real issues for their business. But what they saw instead was that those terms are tighter so that private credit has a seat at the table and, you know, behaves as a partner, as Denise was saying. When circumstances warranted it, when COVID, you know, turned everything upside down, private credit turned up, waivers were going through, people were putting in, you know, increased capital if the situation warranted it. So, it really did test the asset class and, you know, show its stability.

Denise Gibson, Partner at Allen & Overy  06:31

I think one of the other key factors as to why there has been a big increase in the amount of private capital has to do with what it can deliver in terms of speed of execution. And when you look around, a lot of the cap markets, professionals that sit in private equity firms, a lot of them come from an investment banking background. And so, they are used to having to do all the rating agency presentations, used to having to go on the road to do the syndication. And then they turn up at a private equity fund. And they're being pitched to by private credit providers who are basically saying, come to me, let's get this done. There are no ratings needed. And you don't have to worry about going to syndicate this debt because I'm going to be there for the whole ticket. I think that is another attractive feature. And I guess tied to that is certainty. Because, of course, when you go to the syndication markets, you are always, I guess, at the mercy of whatever flex terms you've agreed. So, the pricing that has been underwritten may not be the pricing that you end up with. Because if the market does not accept that there will be a degree of flex that you have written into your terms. And again, once you sign a private credit deal, you do have that sort of certainty of terms. So, I think those are some of the key things that have really made this a very attractive option for some borrowers.

Hannah Gates, Partner at Allen & Overy  07:42

And again, to reinforce that point through COVID, we saw borrowers who already had relationships with private debt funds able to capitalise really well on market opportunities through COVID. Because they could move very quickly with their investors. And they could quickly get more debt in if they saw an opportunity to either do an add-on or to expand their business, or equally if they were finding themselves in a sort of short-term liquidity crisis. Because once you've got that relationship with private debt, they already know your business and they can move very quickly through their IC (information coefficient). They don't have to take market soundings or anything like that. So, they can move very quickly, basically, as the lawyers can do the documentation, they can move into actually making that data available to you.

Tom Kehoe, AIMA  08:29

So, if I can jump in and just take you up on one of the points that you made, Denise, which is on the stage regarding private credit markets development, where would you gauge that stage? Where are we in terms of the private credit market development? And then my question is two parts. Are we still then in the education phase, for both investors into private credit funds and their potential borrowers?

Denise Gibson, Partner at Allen & Overy  09:00

Yeah, I think it's a great question because I think the level of sophistication in this market has just gone from strength to strength. And I really don't think there are any pockets of the market now that private credit is not able to access. But I do think that there is still some road to run and there are still developing areas.

Hannah Gates, Partner at Allen & Overy  09:24

I mean, I think it's fairly well recognised that we sort of tend to follow step-in-step the US market where, you know, there's a bit more maturity in the private debt class. That market is still growing. So I think we can see from the US model that while Denise says, you know, private debt has shown that it can access every type of asset class, you know, we've seen more and more in real estate, you know, we're seeing longer-term funds raised on a bespoke basis to deal with some of the decarbonisation projects that are needed, etc. So, we've seen that private debt can perform for every asset class, we've seen that in the US, more of the market goes towards private debt, and, continues to expand. And I think until we find some kind of ceiling in the US market. It's too early to talk about ceilings, on kind of the size of expansion of the private debt market in the UK, and certainly the rest of Europe and obviously, APAC.

Denise Gibson, Partner at Allen & Overy  10:25

Well, I think then picking that up, I guess from the other side, you could actually say, could the syndicated market learn a thing or two from the private credit market, because there are actually certain credits, and certain businesses that frankly, the syndicated market cannot support, because you basically need to have certain criteria in order to be, you know, an asset that can actually be sold into that market. And I'm thinking about, actually looking at Hannah and some of the transactions she's worked on, you know, if you've got a small sort of startup business, and it's not necessarily even positive yet, this is the type of thing when private credit can do stuff that other markets can't do for you, right. And you can effectively have the flexibility built into the document, that you start out with something that looks quite different. And then once you reach a certain KPI, you can flip into something that then is a more sustainable sort of documentation to survive for that business as it moves through its journey.

But, coming back to your original question, about education, I guess, for the private credit market? You know, I think that there is still, and I think a lot of the concerns have been allayed, but, I think there is still partly this sense of, you know, will there be enough capital to deploy? Will you be able to continue to support this business going forward? Are you just going to run away with the keys, you know, there's some of that old mentality from more of the special situation type funds. And so, I think some people still need to catch up with the fact that the private credit market is just not that market. It's a very different mindset. And we talked a lot about that, previously, in terms of, you know, the support shown by the private credit community, to a lot of the portfolios that they lend to, during the COVID pandemic. And then I think the other thing is, as the private credit investors have effectively moved up the food chain, as it were from sort of the lower mid-cap deals, which are very tight documentation and very closely controlled, it's tied back to that relationship point, I want to know everything you're doing, I want to follow you every step of the way. But actually, as you start doing deals in the upper mid-cap, and you're dealing with financial sponsors that historically have always had much more freedom because they're more in the institutional market, you have to find a meeting of minds in terms of, you know, which bits are you going to let me get on with, and which bits do I need to come and talk to you about?

I think that this is a thing which evolves and, frankly, is a bit of a deal-by-deal discussion. But I think that's probably where the market is still. No one's quite landed on that yet. And when you think you've landed on it, then you hit the current economic climate, and suddenly, you're moving, you're moving in a different direction again. So that's kind of interesting for us as well.

Drew Nicol, AIMA  13:02

So just picking up on the tech education point, because I think just going back to the report for a moment, something that came through was this focus on globalisation. So, when we're talking about the education phase, obviously, that renews or at least starts again, whenever we move into something else. And I think Asia was one area that was particularly highlighted. I'm sure we'll bring Michael in on this a bit later. But just for now, can you just talk us a little bit about your experience in expanding and how the market as a whole is evolving and becoming more diverse?

Hannah Gates, Partner at Allen & Overy  13:33

Yeah, absolutely. I mean, this is a subject that's very close to my heart, in particular, because it's part of why I love the A&O platform, right. We're very proud of our multi-jurisdictional direct lending specialist capabilities across asset classes as well. In Europe, you know, we're continuing to see increased interest in Italy, in addition to the UK, France, Germany, Benelux and also in Eastern Europe, we're still seeing a fair number of direct lending deals, and it's increasing and that hasn't completely stopped even in the current climate. That is very much matched by the respondent's answers to the survey questions in the report.

Obviously, we're seeing exponential growth in APAC, which again, matches the findings in the report, both in terms of assets under management, with LPs based in APAC taking an increased interest in local managers rather than looking to international managers, and the relatively new fund formation regimes in Hong Kong and Singapore helping contribute to that growth, and also in terms of where private debt capital was actually deployed as well. So, both where it's raised and where it's deployed, increasingly there's a huge APAC market. And again, as I say, it's not surprising that our experience matches the aggregated data from survey respondents in the report.

Tom Kehoe, AIMA  14:54

The report has some interesting data on the evolving use of covenants within the various deal frameworks that are arranged between borrower and lender. Could you explain to our listeners who are maybe not that familiar with this area as to what a covenant is? And your thoughts on how this feature has been utilised in the private credit market as opposed to public and broadly syndicated credit markets.

Denise Gibson, Partner at Allen & Overy 15:24

To start with the basics, a covenant, I mean, we're talking about a financial covenant here, we're talking about something that gets tested quarterly. So, it's called a maintenance covenant. And the real idea of this, it's a proxy for the health of the business. And actually, the most common one you see in the LBO world is a leveraged covenant unsurprisingly. So that's basically measuring the company's debt to the company's EBIT, da. And there are other covenants that you see you can see liquidity covenants, you could see a fixed charge cover covenant, some sort of interest cover covenant. So there are lots of different types of covenants, minimum EBITA, but I think for the most part, when people are looking at covenant trends, they're really focused on this leverage covenant. And it's always a very topical debate, like what is the headroom against the model? What is the headroom against the base case? If you set that too tight, you could have borrowers really becoming subject to scrutiny over a hair trigger, if you set that too wide, query why you bother having it at all, because it's really there to act as an early warning sign as we move into sort of distress.

I was having a discussion with someone yesterday about the fact that as the syndicated market moved to cov-lite, so let's just pick up on that. Cov-lite is where you don't actually have a maintenance financial covenant, you're not testing every quarter, and you effectively only have to test on your working capital facility, not your institutional line. And you only do that if that working capital line is drawn to say 40% on one day, in the quarter, which happens to coincide with the testing date. So, you can end up in a situation where you're never really having that ongoing health test. And it begs the question about what we're going to see, as we sort of have this macro-economic climate now where everyone's expecting restructuring to become bigger, but it's a lot slower than people were expecting. And one could argue it's because there isn't, you know, that sort of ongoing health check.

But in any event, I think that if you look at the high-yield market, for example, they don't have any maintenance covenants at all, it's a very encouraging space, just come and test the ratio, if you want to do something. So, you know, we saw a lot in the syndicated market, in the high yield market, that things moved into this incurrence phase. Rather than having, you know, an ongoing quarterly, let's just have a sense check here about the health of this business.

Hannah Gates, Partner at Allen & Overy  18:11

And to Denise's point there, you know, it very much is tied to the different nature of the investing across those different products. So high-yield bonds, sort of, conceptually, were intended to be products where investors hold small amounts of the debt. So, they're diversifying by way of holding a small ticket across a large number of companies, and not really paying the same amount of attention to the companies that they hold debt in, because their ticket is so small. So, they're instead really looking at the markets, they're investing in on an aggregated basis, assuming an intelligently set level of defaults and having an appetite to accept those defaults. And therefore, they're not really investing the time and getting to know the credits that they're holding debt in, totally different to how the private debt market operates where you have larger tickets, you achieve diversification through, you know, assigning those two different funds managed by the same portfolio manager. But that manager has a huge amount of debt across the board, across funds invested in that company, and takes an active interest in the health of that company. And that's where increased reporting and the covenant and other features of the private debt market help with our ongoing relationship.

So, when the market was flush with liquidity, and particularly in the upper part of the private debt market, where investments are in larger EBITDA companies and perhaps on a clubbed basis with other private debt providers, they're getting a small step closer towards the kind of analysis that you'd make in in the high yield market. In those conditions, we do see deals in the private debt space without covenant, whether they're done on a cov-lite basis for those with strong credits in the larger EBITDA space. It's not all direct lenders that can do that. And in the report, you know, the data shows that somewhere around 43%, I think, if I'm reading the bar chart correctly, of respondents saw more financial covenant protection over the last year than previously, which is understandable given the events of the last year. So, it's a market that is perhaps more responsive in terms of using covenants as a tool to reflect views of the macro-economic conditions,

Denise Gibson, Partner at Allen & Overy  20:47

The other thing to notice that is, it's one thing to have a covenant, but it's also the increased focus from these private capital providers on what that covenant looks like. So that comes back to talking about the headroom that you should be setting. And also, what sort of EBITDA adjustments are you going to allow? Because there is typically a degree of being able to inflate your EBITDA with what you're expecting to happen and what you've committed to doing. And, I think the private credit community is very good at basically looking at that and figuring out what makes sense in terms of what are allowable adjustments.

Drew Nicol, AIMA  21:21

So, turning to the mandatory ESG question then, because it is something that runs through the report. And yes, I encourage listeners to pick up on that, but I just want to put it to you in a little bit more of a broader sense.

First, what have we learned about the application of ESG principles in the private credit space over the years? And obviously, we've had a few major events come out that may have influenced that application somewhat, could I put that to you first, because last time we were chatting, you brought up this really interesting example of anti-embarrassment clauses. So, I don't want to lead you too much, but, if you could weave that in that will be really interesting.

Hannah Gates, Partner at Allen & Overy  22:01

Yeah, absolutely. I think ESG has evolved somewhat differently in the syndicated markets versus the private debt markets. The reason being is the same basis as the other points we've discussed, where the private debt market just has more of a closer ongoing relationship with the companies that they invest in. So, they can take a more tailored approach to ESG, which really rewards good behaviour across the board and avoids any kind of greenwashing or sort of standardised KPIs that might not be appropriate. And, you know, one example of that is anti-embarrassment clauses that we see more in the private debt market that you wouldn't really see in the syndicated market because they require a level of knowledge about the credit in order to implement them.

So, what those clauses do is they basically say, here's your ESG ratchet, you can have a reduction in your margin if you're meeting X, Y, Z KPIs and the ESG space, but only if you know that there's no kind of macro events relating to your company, or which we consider inappropriate or ESG non-compliant. An example would be a situation where a business quite clearly has some very negative reporting around their ESG practices, but also simultaneously has managed to hit enough of their KPIs that they would otherwise be getting that margin reduction. In that situation, when you have knowledge of that, and when you have that kind of close relationship to give them an ESG discount on their margin is not appropriate, right? And that's the kind of closer monitoring that private debt is capable of doing, which really allows investors confidence that when they invest in ESG-related private debt assets, they are much more closely attuned to appropriate ESG criteria.

Tom Kehoe, AIMA  23:55

If I was to jump in, I guess then I mean, private credit would be the one space where, you know, you can truly align interests between the borrower and the lender, right?

Hannah Gates, Partner at Allen & Overy  24:05

Absolutely. And you see a lot of close collaboration around that, not to kind of steal your plug if you were about to mention it, but obviously the ACC (Alternative Credit Council) has done a lot recently on this ESG Integrated Disclosure Project, right, which is really exciting in terms of coming up with some standardised reporting, which is really going to help both borrowers and investors focus on what matters in the ESG space. I think that's really exciting.

If we do ever hear a complaint around ESG it's mostly to do with just the volume of, you know, checklists that you get from different lenders etc. So, interests are aligned in terms of the outcome expected around ESG, but maybe not aligned in terms of the amount of churn of paper in responding to each lender's separate checklist. So, you know, I'm sure you're excited about it because you built it, but we as you know, players in the market are very excited to see you're ESG Integrated Disclosure Project.

Tom Kehoe, AIMA  25:01

No, indeed. And there has been a very healthy take-up already since we launched this template last month. So, we continue to watch that with great interest. In terms of a final question, then to you both. Is there anything that surprised you or stood out to you from the findings of Financing the Economy report?

Denise Gibson, Partner at Allen & Overy  25:27

The good news, I guess, Hannah and I was talking about this earlier, and the report is just a really great tool for I think consolidating and reinforcing the trends that we've been seeing in the market. And that was good news to us because it means, you know, we seem to have got that right. So that was encouraging. I think one thing that stood out to both of us actually was, it seems obvious but it probably is not something we've given a lot of thought to before, is how many of the respondents say that they'd like to do more non-sponsored lending. And even throughout this discussion, we've talked a lot about the borrowers, but really, usually by reference to sponsor portfolio companies. So, I think it will be interesting to see how that response translates into actually getting that penetration into the non-sponsor market.

I guess the other thing that we've been talking a lot about, is, you know, the private credit market and the syndicated market, what does the future look like for them sitting alongside each other because there has been even before the macro events this year that has resulted in the syndicated market being largely closed, there has been a growing competition for similar assets between these two markets. And I think people are looking at that and wondering what it's going to look like going forward. And I mean, if I have my crystal ball, my guess is, there will always be for as long as I will be around a very important need for syndicated markets as well. If you think about the record volumes of 2021, it's just difficult for me to see how the private credit market is going to be able to, in the medium term, absorb that ignoring for a moment whether they've got the capital to do it, just from a resourcing perspective, like how many ICs can you go through in any one week. So as the M&A volumes return, and there is more certainty around how to price risk in the underwritten market, my best guess is that we will come back to something that looks probably a bit more like 2021 than 2022 when 2022 has been 100% pretty much private credit, I think there will be a space of both. But Hannah, what's your crystal ball?

Hannah Gates, Partner at Allen & Overy  27:34

I totally agree. I mean, there are always going to be investors with an appetite for diversification through very small holdings in a very large amount of debt across different companies. And there will always be investors that are more interested in knowing that their investment is more researched, and more regularly monitored on a partnership basis. So, you're always going to have that range of investors looking for protection in different ways. And while you've got that, there's always going to be a place for both the syndicated market and also the private debt market.

Another really interesting topic in the report is obviously around interest rates, which is hugely topical right now. The private debt product is largely interest rate linked, so floating rate, which obviously is a very good thing as long as the borrower is able to continue to sustain servicing of that debt. And what I found really interesting in reading through the report is that a large number of respondents have actually already modelled in increased interest rates for some time now and have been expecting those to go up. So that provided me with a lot of confidence, thinking about our sort of portfolio of deals that we have acted as lawyers on in terms of their ability to sustain increased higher levels of interest.

Tom Kehoe, AIMA  28:57

And you can read more about the private credit industry and the health of the industry, including emerging themes that we found in the 2022 Financing the Economy report here, and on the Allen & Overy website. So, all that is left of us then is to thank both Denise and Hannah, for taking the time to speak to us on The Long-Short, and to all your colleagues for providing support and putting together this very timely report. So, thank you.

Both  29:25

Thanks for having us.

Tom Kehoe, AIMA  30:23

Welcome back to The Long-Short. And with us now is Michael Small, who's a Partner in credit markets at KKR. Of course, KKR contributed to this year’s Financing the Economy report. Michael, you're very welcome.

Michael Small, Partner at KKR  30:38

Great. Thank you for the opportunity. Looking forward to talking to you guys today.

Tom Kehoe, AIMA  30:42

A key finding from this year's report is that global private credit managers deployed an estimated $127 billion during 2021. That was a 20% increase in the number we reported in our previous year's report. So, I'm guessing, Michael, that the changing macro landscape this year has had an impact on private credit, what can you tell us about deal flows and investor interest in private credit?

Michael Small, Partner at KKR  31:12

So, it's been a very unusual year. The first half was broadly business as usual. And since then, we've seen this massive dislocation across the board in risk assets, which in our little world, manifests itself most aggressively in the complete absence of issuance of syndicated loans and bonds. And that's important because private credit as an asset class is in competition with syndicated credit and bank-led credit. So, we've seen a dramatic drop off in the level of M&A which pumps primes for the entire system. But, because of the closure of the syndicated markets, we've actually seen private credit step up and take more market share. So, I expect when this year is finished, volumes will be down year on year, but not nearly as much as you would expect if you just look at the headlines because of that capture of market share. And we've seen that in primary buyouts.

We've also seen it interestingly, where existing issuers who need incremental financing have come to the private credit community and asked us to put in place what we call non-fungible tranches. These are bits of private credits that sit alongside syndicated loans and bonds in the capital structure of large companies that typically distribute their risk through syndicated markets. So, when we decompose activity this year, it's very different to what we've experienced in the last vintage. I think the risk profile is quite attractive because we've captured exposure to larger businesses. And obviously, pricing has gone our way. Most of what we do is floating rate, base rates are significantly higher. And we've actually seen spreads widen a little bit as well, as it relates to the question around investor interest. I mean, it's very nuanced. The denominator effect has been well-publicised and well-spoken about. That led to a dramatic slowdown in the rate of fixed capital formation. To some extent, that slowdown has improved how attractive the market is just with simple supply and demand microeconomics.

We're all very focused on 2023. I think everyone, whether you're a high net worth individual, whether you sit in a pension plan, insurance company or a sovereign wealth fund, is reassessing how they want to allocate capital across various asset classes as we transition into this brave new world. And I really don't think, until we get into the body of 2023, we're going to have high conviction as to what the landscape really looks like.

Tom Kehoe, AIMA  34:01

And Michael, just some of our listeners who may not be aware of that term, which is referenced in the report, the denominator effect, what do we mean by that?

Michael Small, Partner at KKR  34:11

So private credit has grown exponentially, largely because institutional investors haven't been able to generate the yield they need from traditional products like government bonds and investment-grade loans and bonds. So, they've been allocating to alternative assets. And private credit is a big part of the alternative asset industry. Many institutions have guidelines as to the maximum percentage of their portfolio that can be an alternative at any point in time. And let's say for the purposes of this, hypothetically, it's 10%. Many of them were nudging up towards that 10%, maybe 8 or 9% of their plan was allocated to alternative investments. And then when we saw the dramatic sell-off earlier this year, the value of many of their liquid holdings which describe the largest part of the plan fell in some instances by 10, or 20%. That's the denominator.

So, you had an alternative allocation going from 9% to maybe 11, or 12%. Because the broader value of the plan had declined quickly. What that meant in a lot of instances is they were unable to allocate more capital to alternatives until that situation had been reversed, or until they've managed to get approval from their board, from their trustees, from their CIO, to change the cap. And that's not something that happens quickly. And it's one of those things I think's getting debated at the moment as people look at 2023, and how they want to construct their portfolios in this high inflationary, high-interest rate environment.

Drew Nicol, AIMA  35:45

The report poses the question of whether there is still an illiquidity premium in the private credit market. And that's something that I think, runs through a lot of the data and the answers that we got, which I found particularly interesting. But in terms of your perception of how investors are maybe becoming more comfortable with the illiquidity of private credit, is it still as big a concern as it was in previous years? And maybe, as Tom says, for our listeners, you could start by maybe, very briefly outlining what we mean by the illiquidity premium.

Michael Small, Partner at KKR  36:21

The illiquidity premium reflects the incremental return you capture by providing credit as a private investor versus doing it through broadly syndicated markets. And generally, it's around 300 basis points, or 3%, sometimes a bit higher, sometimes a bit lower, depending on market forces.

Very recently, there's been little to no primary issuance of syndicated credit. So, it's been quite hard to assess faithfully what that illiquidity premium is. And so, people have looked to the secondary markets, and looked at the implied pricing of syndicated credit through where you can buy loans and bonds in secondary as a way of deriving what the illiquidity premium would be today. And we've seen some compression because if I think back six or seven weeks ago, high-yield bonds, for example, look extremely cheap, it looked like they'd been oversold, and loans had sold off, too. And so, there were times that the premium looked like it may be as narrow as 100 or 150 basis points. If we wind forward to today, and the landscape is very dynamic, things are almost changing on a weekly basis. The premium, if we look at secondary markets, is probably back to around 200 to 250 basis points.

This week, we have a number of primary deals in the US market. If I look at where those primary deals suggest they might price, I feel we're back to that 300 basis points of premium for private credit over liquid credit. As investors think about liquidity generally, and how they consider it in the context of how they make their own investment decisions, I think it's a mixed bag, I think it very much depends on the type of investor and what they're looking to solve for those who don't need near term liquidity in their portfolios. Private credit is and will continue to be a very important component of what they do. For those that need liquidity or need to preserve access to liquidity, it's a harder thing to position because the underlying loans aren't liquid. And generally, the way we raise money is through structures that don't have inbuilt liquidity.

I'm probably a little bit biased on this because private credit is what I've done for all my career. But what I'd observe, if you consider the liquid markets is their liquid to a point. But when you really need liquidity, it tends to dry up. There's no empirical evidence to support that unequivocally. But I think often we get sucked a little bit too far into this liquid versus illiquid debate. Very generally, whether it's a loan or a bond, whether it's private or liquid, it's a credit instrument, and we should just assess them on their merits at each point in time, recognising elements of loans and bonds, or maybe a little bit more liquid than private credit, but I don't think it's as dramatic as certain commentators would like us all to believe.

Tom Kehoe, AIMA  39:22

Michael, the retailisation of the market, that's an interesting trend that we marked out in this paper, as been mentioned as well more widely. What can you tell our listeners about this?

Michael Small, Partner at KKR  39:35

So, I think it's part of the natural evolution of any asset class. So historically, private credit has been almost exclusively financed through institutional money. If we actually look at where capital sits globally, big portions of it aren't within institutions. They sit within commercial banks, or for example, in the personal pension plans of individuals and it doesn't need to be a high net worth individual, just people generally. So, most people in this industry are commercially minded. Most of us are running businesses where there is a premium on growth. And so when we consider what we want for our industry and our firms to look like on a 5 or 10 or 15-year basis, finding some way of accessing that non-institutional money has to be a good thing for the long-term health of the industry, because it broadens the scope of capital that we can have access to invest, and also diversifies our own capital basis, which is a good thing if you just think in the long term about liquidity and risk. Now, it's a very different proposition to raising money from a very large multinational insurance company or sovereign wealth fund. And so credibly, I think, as an industry, we are treading cautiously and thoughtfully about how we do this. I don't think it's a sprint, I think it's a marathon. But I think in the long run, it's something that is healthy and inevitable.

Drew Nicol, AIMA  41:05

And something else that jumped out at me that I'm really keen to put to you is this idea of the globalisation of private credit because when I was in Singapore earlier this year for our APAC forum, private credit came up far more than I expected it to as a growing trend for the region. And, again, it's come up here in our reports, so what can you tell us about that? And specifically, how has your business done when it comes to exploring new markets and strategies,

Michael Small, Partner at KKR  41:33

I mean, the globalisation trend to me again, it's just natural. I mean, private credit is not specific to Europe or North America, it's just a different way of extending credit to either a corporate or a pool of assets. And we all forget, you know, people have been lending money for centuries, if not millennia. And we tend to love to label things and silo things and overcomplicate them.

If we look at Asia, today, there is a large amount of uninvested, private equity, dry powder, and a lot of private capital, looking to purchase good quality businesses, the banking market in Asia, is not super deep. Neither is the syndicated loan and bond market. So, in order for those prospective buyers, to satisfy their desires, to go and buy these great companies, they're going to need financing. And it's likely in a lot of instances, the local bank market or the bond market doesn't give them quite what they need, which is a great opportunity for private growth. And I think that's why you're picking up a lot of discussion around it. And that's why there are a lot of firms like mine, spending a lot of time building a foundation there. Because there are elements of Asia, to me that feels quite similar to Europe maybe 20 years ago, and perhaps North America 30 years ago, where you could see there was a very interesting opportunity to provide financing to companies in a way that wasn't necessarily and totally through the commercial banking market. And I think, in a very long period of time, I'm talking multiple decades, the distinctions we observe today, in private credit between North America, Europe, and laterally, Asia, will become less and less obvious, and it will become a bit more homogenous in terms of product, the way one deploys obviously will always reflect local nuances, the legal code, cultural customs, but generally, what we need to accept is its lending money. It's not rocket science.

Tom Kehoe, AIMA  43:27

Michael, what do we know about the changing demographic of borrowers that are accessing private credit now?

Michael Small, Partner at KKR  43:33

I think the most obvious and powerful part of that which is highly correlated to the growth of the private credit industry is the size of borrowers, as each year goes by, I think the average EBITDA of borrowers within private lenders' portfolios is going up. And that can only be a good thing. Generally, large mature companies tend to be more stable than small growing companies. And stability is a very important part of being a lender through the cycle. I think as an industry as we've captured more capital, it's allowed us to do that and be a credible financing source for companies with 100/200, or even more, million euros of EBITDA. So, these are large businesses, either national champions or multinational platforms. I don't think that trend can continue ad infinitum. Because at some point, you can't have private credit doing the exact same thing as syndicated credit. But I still think there's an incredibly long runway until we even get close to that challenge.

Tom Kehoe, AIMA  44:39

Now, in the report, if I may, you're quoted as saying that if M&A, mergers and acquisition, activity picks up, which is our base case, we can see a really interesting vintage for private lenders as there will be less heat in the syndicated debt markets. New deals will then have lower leverage, higher coverage ratios and improved pricing and documentation. And we believe this will be the case for both senior and particularly junior private debt. Can you elaborate on this?

Michael Small, Partner at KKR  45:12

With pleasure. As we transition into the next cycle, people are going to place a premium, I think, on buying high-quality resilient companies. And I think correctly, the value of which they can purchase those companies is going to stay high. Many buyers will want financing. Very recently, for big companies, the most obvious and cheapest way to finance was to get a rating and issue a syndicated loan or bond. And so, as a private credit community, we're always competing with that in terms of what's the next best option for the borrower.

Next year, senior syndicated leverage is going to be lower than it's been in the past, for two reasons. One is objective, and that's with interest rates being higher to solve for the same coverage ratio, you would put less debt on the business. Secondly, there is going to be less excess liquidity in the system. So, at the margin, there is going to be less money flowing into loan and bond funds, which is going to mean investment banks are less inclined to do something aggressive in terms of the capital structures they underwrite, which will make private credit more competitive than it has been historically, for some of these larger companies I was referring to earlier. So, I think the opportunity set will be wider, leverage levels will be lower, and pricing is attractive, both relative and absolute when we factor in base rates and spreads. And I think that's going to be true for both senior private credit, but also junior private credit. And the one imponderable in it all is, when will the M&A machine startup? Again, I don't have a crystal ball. But I would venture a guess it's going to be at some point in 2023.

Drew Nicol, AIMA  46:54

I do want to give you an opportunity to get your crystal ball out. But before we do, we've obviously been guiding you until now on what really stood out to us in the report. But is there anything that stood out to you? Or was particularly interesting?

Michael Small, Partner at KKR  47:10

Yes, I mean, the thing that I found most illuminating was the skew to a number of your respondents towards the UK, and also smaller companies. I think a lot of the information, understandably, is being captured looking in the rearview mirror, because people are responding in the context of what they've done, rather than what they expect to do. But I think on a go-forward basis, just given macro fundamentals, and also, you know, general fear aversion, given we are going into a recession, I think we'll see managers skew a little bit away from the UK, and try and skew to larger companies in a flight to quality if it were in terms of size of the company sector, and their defensibility, given the headwinds they're facing. So, it's going to be very interesting for me and your other respondents and readers to look at the report in 12- or 24-months’ time, and let's see how things have evolved. And whether we've done a good job as an industry of adapting. It's sort of our Darwinian moment, I think there are a lot of upsides to capture. But also, for those that perhaps are a little bit slow to adapt, or perhaps can’t. I think there are going to be some tough times ahead.

Drew Nicol, AIMA  48:22

Finally, then returning to that, that billion-dollar question that I think we've alluded to, in a couple of different ways. So far, private credit seems to be performing well this year. So, there's always a little bit of lag on that. But I do have to put it directly to you, do you predict this to continue? Is there anything you want to add further to that idea around different aspects of direct lending? And maybe are there any regional nuances to this question?

Michael Small, Partner at KKR  48:50

I don't think we're facing any existential risks in terms of performance. I think generally, the industry is populated with smart people who are experienced, that understand credit fundamentals. The environment we're in, none of us saw it coming. Or if we did, we didn't expect it to happen quite so precipitously and aggressively. And at a macro level, we're seeing things I've certainly never seen in the last 25 years. And we're going to see an awful lot of stress on the gross margins of companies because they've got the twin towers of increasing costs, and to some extent, declining demand at the same time. And that's going to be very obvious in certain sectors.

I think it's going to be more obvious in small companies than large companies because they're just less well equipped, given where they sit in their value chain to pass increased costs through to their customers. So, we will, as an industry, see some stress. We are going to see some defaults. Many might just be based on interest rates, where you amend the debt and life goes on, but some will be a function of operating distress and that's where I think we're going to see over time, the worst performance. I don't think it's going to be country specific. I think it's going to be sector and size of company-specific.

Drew Nicol, AIMA  50:11

That's interesting. And I'm glad you brought up the issue of this dynamic of rising interest rates, in some senses being good for the sector, but obviously, bringing with it the risk of default. And it's interesting you are saying it's more sector than then regional-based. And I guess that may well be the focus of next year's report. So, you know, unfortunately, that is all we have time for. All that's left is for me to thank you so much for coming on The Long-Short today and giving some really valuable colour to the data. And just as a reminder to listeners, the report is available on the aima.org website, or you can find it in the show notes. So, Michael, thank you so much.

Michael Small, Partner at KKR  50:51

It's been a pleasure. Goodbye.


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