Mind the Curb: Upcoming Test For Private Markets

Though the alarm bells on the liquidity crunch in private credit have faded, there are new concerns about the underlying loans in private credit vehicles. In a recent article^[1], The Wall Street Journal highlighted a $300 billion looming wall of maturity of poorly rated loans coming due over the next three years. It stated a material portion of these loans are struggling software companies backed by private equity buyout managers — and that managers must find a way to refinance these loans at much higher rates or hand the keys back to the lenders.

Should private market investors be worried? We believe that some should, but markets are usually more adaptive than the headlines give them credit for. In addition, we don’t believe investors will need to climb a “wall of maturity.” This situation is much smaller in scale, so it’ll be more like stepping over a curb.

The wall is more like a curb

A $300 billion wall of maturity coming due over three years is a lot of money in any scenario, but it is just 1/12^th of the $4 trillion real estate debt wall of maturity that investors faced two years ago. Despite concerns about climbing this wall, markets are dealing with it. While defaults and write downs have occurred, refinances, new pools of capital, and loan sales are slowly chipping away at the problem for real estate.  With markets climbing this wall, we believe this situation is more like stepping over a curb. According to Pitchbook, private credit is sitting with $547 billion of dry powder while private equity has $997 billion. We assume this dry powder from private credit can absorb a portion of the coming maturities, while dry powder from private equity managers can infuse capital into the company to allow it to continue to operate.

There will be blood

Whether it is a wall or a curb, we do expect there to be some big name defaults. It is hard to imagine a disruptive technology like artificial intelligence coming onto the scene and not breaking something. As the oil price bust in 2014 - 2016 claimed victims such as Quicksilver, Linn Energy, and Samson Resources, we expect there to be defaults and bankruptcies in software companies.

Defaults in non-software companies would also not be a surprise. While other sectors have not had the disruption that software has had over the last three years, higher inflation and higher rates take a toll across many sectors. Private equity managers that choose not to, or cannot, infuse struggling companies with cash will find themselves handing back the keys.

Investor experience will depend on their manager selection and diversification. When a private equity manager hands the keys back to the lender, it is up to the lender to recover as much value as possible for their investors. At Balentine, we prefer to partner with managers with an internal workout team that can be deployed into these companies to try and salvage value.

Some of the best outcomes in private credit occurred in the face of defaults. This is because the private credit manager typically only lends at 50% of the value of the company, so on day 1 of the takeover, they only need to recover 50 cents on the dollar to be made whole.

Diversification is also key. Pitchbook estimates 32% of distressed loans are software companies. If investors are not broadly diversified across the private credit spectrum, their portfolios could be geared into software. At Balentine, we pair direct lending with asset-based lending, healthcare growth capital lending, and private credit secondaries. This makes our investors much less exposed to the coming wave of software loan maturities.

On the equity side, we have shied away from heavy exposure to software and technology on the buyout side, preferring managers that focus on industrial, housing, and aerospace sectors and drive value through operational improvement versus high use of debt and financial engineering.

Distress creates opportunity

Stress in one part of the market creates opportunities in others. Rescue financing for good companies with bad balance sheets typically commands higher spreads and stronger terms. Private credit secondaries can acquire loan portfolios at discounts to their value, while private equity secondaries can help infuse much needed cash into companies at very favorable terms. A disciplined allocation to these strategies can allow investors not only to manage through a maturity wall, but to benefit from it.

While we do expect defaults among borrowers over the next three years, we don’t view a $300 billion maturity wall as a systemic threat to the private markets. Like commercial real estate before it, this is likely to be worked through over years, through refinancings, sponsor equity injections, loan sales, and in some cases lenders taking the keys.

For investors, the outcome will be determined less by who their managers are and what they own. Portfolios built with experienced workout capabilities and diversified across lending and equity strategies should be positioned not just to weather this cycle, but to find opportunity in it.

^[1]Source: Wall Street Journal

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^{This information has been prepared by Balentine LLC (“Balentine”) and is intended for informational purposes only. This information should not be construed as investment, legal, and/or tax advice.   The opinions expressed are those of the Balentine Investment Team. The opinions referenced are as of the date of publication and are subject to change without notice. This material is for informational use only and should not be considered investment advice specific to your financial situation.}