10 min read 23 Mar 22
A double whammy of higher inflation and rate hikes (with the Bank of England having raised short-term interest rates by 0.75 percentage points since December) together with worries about new Covid variants (Omicron, namely) gripped markets over the past few months. Entering a new year, market observers assumed that the risk of a policy error was the biggest (known) risk that investors potentially had to contend with in 2022.
Amid the ongoing war in Ukraine, global financial markets are understandably rattled with sharp price swings being observed in some sectors, while investors also weigh up the impact of western sanctions imposed on Russia’s economy and financial system. Much is still unknown at this stage, but sanctions on one of the world’s largest energy producers will have the effect of pushing up prices of energy and other commodities.
Higher energy prices will only add to upward pressure on a continental Europe that is heavily reliant on exported oil and gas supplies from Russia (20% and 40%, respectively) with supply chain disruptions and labour shortages having already pushed prices higher and Eurozone inflation to a record high over recent months. In the UK, the single largest source of gas is from the UK Continental Shelf and the vast majority of imports come from suppliers such as Norway, with imports from Russia making up less than 4% of total UK gas supply in 20211.
The extent to which still-higher prices could impact consumer and business confidence (and activity levels) across Europe, will nevertheless be important from an economic growth perspective. Wider signs of distress remain absent from markets and corporate default rates in Europe remain very low. Our RADS team, however, notes that various European businesses which have been previously reliant on sales to Russia could see a drop-off in earnings as they pull back from that market, and capital structures may need to be adjusted to reflect this. Similarly, supply disruption and sustained higher prices for oil and gas could have cost implications for businesses operating in certain sectors.
Central banks will certainly be keeping a watchful eye on key macroeconomic indicators in the weeks and months ahead.
In an environment of rising inflation, we would reiterate that floating-rate private credit assets and instruments potentially offer attractive protection against interest rate increases, helping to ensure stable income-driven returns. Read our latest paper on the potential advantages ‘high carry, low duration’ private credit assets could offer fixed income investors in a period of higher inflation.
As the situation unfolds in real time and the wider ramifications become clearer, publicly-traded markets will likely experience further volatility and uncertainty in the short term.
It is worth recalling that even at the height of the Covid-19 induced volatility in March 2020, episodes of technically-induced spread widening presented opportunities for active investors to pick up quality credits at more interesting levels. Back then, central banks were quick to come to the rescue and shore up markets amid dwindling public market liquidity and weakness. So far this year, and as of writing, European credit spreads have widened with investment grade (IG) indices back to late 2018 levels, amid low volume trading. Our public fixed income colleagues note that continuing to stabilise markets through quantitative easing (QE) programmes will stoke demand and inflation at a time when supply side inflation is coming through, and suggest that current market valuations do not reflect the risk that central banks start to unwind stimulus, with the immediacy of the Russia-Ukraine conflict stealing focus.
More broadly, we expect private and illiquid investments will remain relatively insulated from the turbulence and impact of volatility that is divorced from the fundamentals of many businesses and assets. There are areas of the short-dated private credit universe which have spread inputs to pricing and may experience increased volatility a result of sentiment-driven market moves in public markets. However, the majority of private credit assets we invest in are model priced, and those prices also usually have public market credit spreads as an input. This means that while they are not immune from mark-to-market volatility, they are somewhat muted.
Given our innate flexibility to look across the diverse universe of private credit assets – including private corporate lending, consumer finance, real assets lending and structured credit – we are encouraged about the breadth of attractive risk-adjusted opportunities that have emerged over recent months, with the fourth quarter of 2021 proving to be particularly robust in terms of deployment levels.
We have been observing a diverse array of opportunities from across the private credit spectrum; the fourth quarter traditionally being busy for significant risk transfer (SRT) trades, but also seeing a strong start to the year in terms of direct lending dealflow with a number of interesting opportunities across different sectors coming through as borrower demand for more bespoke lending solutions continues. In terms of private placements, there was an opportunity to renegotiate an existing bilateral transaction after previous notes were called, as expected.
There was a healthy flow of SRT trades during 2021, mostly from UK and European bank originators as transactional volumes recovered to pre-pandemic levels.
Among the key trades in the fourth quarter was a bilateral transaction with a top-tier global bank, for first-loss and second-loss tranches referencing a portfolio of corporate loans from predominantly IG names. While the majority of deals coming to the market offer exposure to large corporate loans and SMEs (representing almost two-thirds of the amount of transactions executed since 2010), we have been seeing a number of trades across a wider range of reference assets including consumer loans, trade finance, capital calls, specialised lending, and even commercial real estate.
Direct lending dealflow has gone from strength to strength following a disrupted 2020. Looking at European market activity levels more broadly, a busy Q4 resulted in the most active year of direct lending since Deloitte began tracking private debt deals in 2012, according to the ‘Deloitte Alternative Lender Deal Tracker Spring 2022: Flash Results’ – which tracks deals across Europe from 68 of the market’s leading Alternative Lenders. Deloitte notes that the total number of deals inked last year “reflects a year-on-year increase of 89% compared to 2020, and 51% compared to the previous record-breaking year of 2019”, adding that “the extraordinary number of transactions comes off the back of a roaring M&A landscape”.
We also pointed to the strength of M&A activity, in our recently-published 2022 Leveraged Loans Market Outlook, with a record-breaking c.US$6 trillion of activity being recorded in 2021 – which helped the European loan market mark a post-GFC record for new issuance at €130 billion; besting the €121 billion watermark set in 2017. Private equity’s (PE) share of the pie also increased – with c.60% of issuance arising from M&A-related activity (versus c.40% in 2017) – as funds started to deploy some of the dry powder that has been amassed from fundraising efforts but not yet spent. Today, PE global dry powder amounts to over $2.2 trillion, according to Preqin Pro figures.
Our Asia-Pacific origination team are seeing opportunities on the structured finance side, in areas such as real estate, particularly in development finance. One example included a financing facility for a fully completed residential real estate development located in Australia.
A more uncertain environment is also creating a need for special situations financings for individual companies and assets that are navigating a changing macroeconomic environment and facing company and sponsor-specific complexities when it comes to capital expenditure. To illustrate, we have seen an opportunity to acquire a UK brownfield development site from an investor that is unable to provide further capital required to grow the business, as well as an opportunity to purchase a portfolio of French logistics assets which also require additional capex to meet new ESG requirements that the existing owner does not consider itself able to commit to.
Elsewhere, we continue to see value-add opportunities in the real estate sectors, including individual assets within often overlooked sectors like retail, which we believe offer the unique strengths to mitigate wider sector concerns.
Private credit investors, while being mindful of short-term headwinds, remain patient and focused on meeting long-term investment objectives, and ensuring broad diversification across portfolios and compensation for the risk taken. Private lenders, in turn, are staying the course amid ongoing uncertainty having proved themselves to be a stable, invaluable presence for existing borrowers and issuers during the Covid-19 pandemic, even as liquid markets briefly seized up.
Private credit assets tend to have low correlation to publicly-traded assets, helping to shield investment returns from periods of wider market volatility and disruption, and possess many in-built defensive characteristics and are typically buy-and-hold investments. The largely institutional investor-base, which has grown over recent years also helps to provide stability. Nevertheless, careful structuring of private credit investments can further help to mitigate against downside risk in portfolios – with strong origination capabilities and flexibility to invest across the full breadth of the asset class also important when it comes to ensuring selectivity over deals.
The origination pipeline of new private and illiquid credit assets is currently both strong and diverse, potentially boding well for deployment levels ahead. The direct lending pipeline has been consistently building over recent months and includes an opportunity to refinance the debt of a European furniture designer and manufacturer. We are also seeing several opportunities across the structured credit universe, including deals which have the potential to offer attractive risk/return.
Our Asia Pacific origination team continues to see a healthy pipeline of potential opportunities and are progressing on transactions at various stages, while we continue to review opportunities in the European leveraged loan market.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.