Private Debt Archives

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We have seen significant fund closings and even bigger fund launches in the opportunistic credit space. Why is that corner of private debt proving so attractive?

Opportunistic credit, or special situations, is proving popular for a lot of the same reasons that private credit as a whole is attracting the attention of investors. The difference, of course, is that opportunistic credit funds offer a potentially greater uplift, particularly if you are talking about heavily distressed scenarios. Those types of restructuring deals come with significant outsized return expectations when the distressed assets get restructured or repositioned.

We have seen institutional investors increase allocations to private credit consistently in recent years to take advantage of the yield profile offered by those investments, which are now in the high single to low-double digits for performing loans, even stretching into the mid-teens. On a levered basis, you can go even higher. When you consider a special situations or opportunistic credit strategy, you are looking at returns in the 20-30 percent bracket, which is clearly attractive. I think that is the fundamental draw these funds are able to offer to investors anticipating a credit cycle correction.

What are the key macro factors propelling this opportunity set in the current market environment?

The impact of higher interest rates is starting to make itself felt. A lot of businesses, and particularly sponsor-backed businesses, are beginning to feel the pressure of that increased interest rate burden. At the same time, there has clearly been a profound impact on the consumer, in terms of maintenance of household budgets and the ability to consume. That, in turn, is having knock on implications for the companies manufacturing and selling products to consumers, especially if they have meaningful levels of indebtedness.

I think those trends will continue this year. We have not seen the same level of refinancing that we did a few years ago. Deals are not being restructured at the same velocity and that is inevitably going to impact borrowers, with structural defaults and covenant breaches pushing some credits into meaningful restructuring scenarios, which is often a precursor to a broader market trend that might lead more distressed opportunities.

There have been some aggressive predictions made, suggesting that private debt default rates could reach 5 percent this year. What are your thoughts on that and what implications could that have for opportunistic credit?

Yes, Bank of America research produced in October last year estimated that private debt defaults would soon reach 5 percent, thereby exceeding de[1]fault rates for syndicated loans, based on the fact that around one-third of deals in debt fund portfolios were due to mature within 30 months. That default risk is certainly one cloud hanging over the private credit industry right now, while at the same time creating potential opportunities for opportunistic credit managers.

Which loans are particularly at risk and therefore where do you see opportunistic plays emerging?

Private debt, as an industry, is still relatively young. It only really emerged as a fully-fledged asset class in the aftermath of the global financial crisis, when banks were retrenching from new lending to rebuild balance sheets and manage legacy portfolios.

Since that time, the private debt industry has expanded rapidly. In fact, according to PitchBook, it has swelled from $280 billion in assets under management in 2009, to $1.5 trillion in 2022, as managers have seized the opportunity to fill the void left by banks.

During that time, private credit has never really had to tackle a true market downturn and many of these credits now maturing were issued in a bull market, characterized by high levels of leverage and loose terms. Meanwhile, some managers, particularly those looking to build market share, took on more marginal transactions with especially aggressive capital structures. Those are the credits that will be particularly exposed.

In general, I would say that larger and more established platforms will have been less likely to chase the market in 2021 and 2022 and will therefore have more resilient portfolios. Those managers are also more likely to be well resourced when it comes to managing out any credits that do fall into stress. By contrast, newer managers with smaller teams are likely to come under more pressure. Ultimately, this could lead to a bifurcation in the private credit market, with top tier firms attracting an ever-larger share of both dealflow and fundraising.

Are there any particular sectors where opportunistic credit situations are more prevalent, in addition to consumer and retail?

With the exception of consumer and retail, I wouldn’t say that there is any pronounced trend with regard to the industry focus of our clients in this space right now. We are still in the early stages of how this interest rate environment is going to play out, so I think it is too early to tell. However, I would say that there has been a fair amount of portfolio rebalancing in the oil and gas industry. A lot of the traditional lenders in that space – the big retail banks – are starting to rotate out.

How is the opportunistic credit GP landscape evolving? Are we seeing many new entrants?

I think the players that have been active in this market for some time are continuing to raise funds to take advantage of the anticipated market dislocation. But I would say we are also seeing new managers looking to build teams in or[1]der to enter the space. Some of these new entrants are big name asset managers with a strong legacy in private equity. Others have a strong legacy in direct lending. They are not only looking to access these opportunistic credit deals, but also to market new strategies and new funds to their existing investor base.

How do you see the opportunistic credit market evolving?

I think that there will be a lot more borrowers testing the limits of their credit agreements. That is going to lead to forced divestment for the legacy credit funds that are currently holding onto those assets. It will therefore also lead to opportunities for opportunistic credit funds to participate.

There will probably be some initial mispricing of risk with those credits, but over time, and as the volume of dealflow grows, I think the market will establish a cadence and risk will begin to be priced correctly.

Perhaps, the biggest issue that I see on the horizon is the fact that some of these broadly syndicated loans are billions of dollars in size, which is not something that special situations of opportunistic credit funds have come across in a while. They have more typically dealt with mid-market private credit loans of a couple of hundred million dollars. It will be interesting to see how managers choose to participate in those situations and how pairings of certain GPs plays out.

This article was originally published in PDI’s Opportunistic Credit and Distressed Debt special report.

Luxembourg, London and Chicago, March 4^th, 2024 – Alter Domus, a leading global provider of end-to-end tech-enabled fund administration, private debt, and corporate services for the alternative investment industry, today announced that it has secured a new strategic investment from Cinven. Cinven is a leading international private equity firm focused on building world-class global and European companies. The transaction gives Alter Domus an Enterprise Value of €4.9 billion ($5.3 bn).

Through the transaction, Cinven will support the long-term strategic growth of Alter Domus, working in close partnership with the founders of Alter Domus and Permira, who will continue to be significant shareholders. Their continued involvement and investment in the firm is a huge endorsement for Alter Domus as a business, its global growth strategy to date and its future potential. The new structure means Alter Domus will now benefit from the support of three fantastic partners in Cinven, Permira and the founders, and this transaction strengthens the capital base of the company enabling it to focus on the next stage of its growth.

Established in 2003, Alter Domus is one of the largest fund administrators globally, with over $2.5tn assets under administration (AUA). Solely dedicated to alternative assets, Alter Domus offers end-to-end tech-enabled fund administration and corporate services across three sectors: private equity, real assets and private debt. With the support of Permira since 2017, the firm has grown rapidly to meet the evolving needs of its client base, building a global network that now spans 23 jurisdictions, servicing 90% of the top 30 asset managers globally. Since Permira’s investment, Alter Domus has increased revenue, EBITDA and employee numbers by 5x.

Additional investment characteristics of Alter Domus that were attractive to Cinven include:

Its impressive financial track record, with Alter Domus having consistently outperformed the market, delivering double-digit organic growth and attractive margin performance;
Alter Domus represents a scarce, market-leading global fund services platform that delivers market-leading service levels to a blue-chip customer base including 90% of top-30 asset managers served;
It is a proven M&A platform in the fragmented fund services market that has a successful track record of acquisitions, and a strong further pipeline of potential buy and build opportunities across a range of markets and geographies;
The company operates in attractive markets, with the fund services subsector benefitting from the structural growth of private capital markets, increasing regulation and a continued trend towards outsourcing of fund services, together with downside-protection through strong revenue visibility and cashflow generation;
Alter Domus has received significant investment in the tech-enablement of the company – resulting in best-of-breed third-party platforms, workflow automation and a leading data and analytics product capability to better serve the increasingly complex needs of its global client base; and
It has an experienced and highly respected management team that has led the strong performance to date.

In little more than two decades, Alter Domus has grown from being a small Luxembourg-based spin-off from PwC to become a world-leading fund administrator. The investment from Cinven is a significant milestone in the development of Alter Domus as it continues along this trajectory. Together with Permira, we are confident that Cinven is the perfect partner as it continues to grow and scale internationally, and I am excited to continue to be a part of the Alter Domus journey.
Alter Domus Founder and Chairman of the Supervisory Board, Rene Beltjens

With an enviable track record of investing in fast-growing, world-class businesses, we are thrilled to welcome Cinven as an investor in Alter Domus. Cinven shares our strategic vision and commitment to developing long-term technology-enabled partnerships with the leading alternatives firms globally through the delivery of operational and client service excellence. Together we look forward to further accelerating our international growth and delivering innovative new services to our clients.
Alter Domus Chief Executive Officer, Doug Hart

Cinven is delighted to make this investment in Alter Domus. Fund services has been a priority subsector for Cinven’s Business Services team due to the attractive business model characteristics and strong growth drivers. Cinven’s Business Services and Financial Services sector teams have worked together in close partnership and have followed Alter Domus closely over many years and admired it as a global leader, with blue-chip clients and leading service levels. Looking forward, we see significant potential for further growth and we look forward to working with the management team and shareholders in the next phase of its journey.
Cinven Partner and Head of the Business Services sector team, Rory Neeson

We would like to thank René Beltjens, Doug Hart and the entire Alter Domus team for their hard work and passion that has allowed our partnership so far to be so successful. The company is now well positioned as a global leader to enter its next phase of growth with the support of an aligned set of shareholders, and we’re looking forward to working closely with Cinven, the founders and management to continue capitalising on the growth opportunity ahead.
Global Head of Services at Permira, Philip Muelder, and Chris Pell, Principal at Permira

The transaction is subject to regulatory approvals and other customary closing conditions.

Alter Domus was advised by Goldman Sachs International and Raymond James (M&A), DLA Piper, Jamieson Group (Dedicated advisors to management), Oliver Wyman (Commercial), EY (Financial & Tax) and Clifford Chance (Legal), Kroll (Compliance), Crosslake (Technology).

About Alter Domus

Alter Domus is a leading provider of tech-enabled fund administration, private debt, and corporate services for the alternative investment industry with more than 5,100 employees across 39 offices globally. Solely dedicated to alternatives, Alter Domus offers fund administration, corporate services, depositary services, capital administration, transfer pricing, domiciliation, management company services, loan administration, agency services, trade settlement and CLO manager services.

Find out more at www.alterDomus.com.

About Cinven

Cinven is a leading international private equity firm focused on building world-class global and European companies. Its funds invest in six key sectors: Business Services, Consumer, Financial Services, Healthcare, Industrials and Technology, Media and Telecommunications (TMT). Cinven has offices in London, New York, Frankfurt, Paris, Milan, Madrid, Guernsey and Luxembourg.

Cinven takes a responsible approach towards its portfolio companies, their employees, suppliers, local communities, the environment and society.

Cinven Limited is authorised and regulated by the Financial Conduct Authority.

In this press release ‘Cinven’ means, depending on the context, any of or collectively, Cinven Holdings Guernsey Limited, Cinven Partnership LLP, and their respective Associates (as defined in the Companies Act 2006) and/or funds managed or advised by any of the foregoing.

For additional information on Cinven please visit www.cinven.com and www.linkedin.com/company/cinven/.

About Permira

Permira is a global investment firm that backs successful businesses with growth ambitions. Founded in 1985, the firm advises funds with total committed capital of approximately €80bn and makes long-term majority and minority investments across two core asset classes, private equity and credit.

Permira is one of the world’s most active investors in the Services sector, having deployed over $11.5 billion to partner with more than 40 companies globally. Current and previous investments from the Permira funds in the sector include: Acuity Knowledge Partners, Axiom, Cielo, Clearwater Analytics, DiversiTech, Engel & Völkers, Evelyn Partners, Kroll, Motus, Relativity, Reorg and Tricor.

The Permira private equity funds have made approximately 300 private equity investments in four key sectors: Technology, Consumer, Healthcare and Services. Permira employs over 500 people in 15 offices across Europe, the United States and Asia. For more information, visit www.permira.com or follow us on LinkedIn.

Media Contact: [email protected]

Katherine-Hope Keown: +44(0)7512 309360

Read Cinven‘s press release here.

Read Permira‘s press release here.

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In the dynamic world of alternative investments, Broadly Syndicated Loans (‘BSL’) continue to be an important part of the market. The Leveraged Loans market as a whole yielded a near record 12% return this year. And CLOs are expected to continue to have high issuance in 2024, with most banks forecasting between 100 and 115 billion in new issuance this year, numbers quite similar to last year’s high level of issuance.

Amidst today’s high interest rates, it’s no surprise that the BSL market has become and continues to be a popular choice for investors seeking attractive yields and a relatively low risk profile. We’ve previously written about BSL characteristics, loss protecting features, and prepayments. We now additionally consider macroeconomic factors that drive prepayments.

As the market grows in importance, investors are increasingly asking how BSLs might perform under a range of macroeconomic conditions. While some discussion has gone into monitoring default risk via stress tests, most stress testing is primarily focused on default risk and instead opts to zero out prepayments as a conservative assumption.

While this creates simplicity, it runs the risk of creating excessively conservative and unrealistic stress tests. This simplicity ignores an important fundamental concept in credit risk – the Exposure At Default (‘EAD’). EAD is a critical component of credit risk – in addition to probability of default (‘PD’) and loss-given-default (‘LGD’).

Using our Risk Modeler Analytics platform, we can adopt a more prudent approach to stress testing that considers both default risks and prepayment risks and ensures that EAD is addressed. Prepayment analysis is also generally critical for BSL investors for proper cash management, including investor redemptions and reinvestment strategies.

In our previous article, we discussed the benefits of forecasting prepayments and looked at a broad set of factors that can predict prepayment rates. However, we did not consider macroeconomic factors, which raises the question: Why might someone want to focus heavily on macroeconomic factors when forecasting prepayments?

Firstly, aggregate prepayments vary wildly across time, ranging from 3% to 12% on a quarterly basis in our sample portfolio. Secondly, these prepayments correlate strongly with macroeconomic factors in ways that are consistent with sound economic reasoning, suggesting that the correlations will hold in future scenarios.

Finally, this opens up the door to incorporating scenario-based thinking and stress testing as a means of driving analysis and decision-making. An important note to consider is that scenario analysis need not necessarily be only regarding stress scenarios.

Given the novel combination of interest rates and inflation in the current macroeconomic environment, numerous different positive scenarios can be constructed with different implications for prepayments. Considering such scenarios is increasingly important for sophisticated BSL managers attempting to do cash flow management.

Modeling approach

As part of our process, we selected a sample of loans from our BSL universe and attempted to model prepayments primarily using macroeconomic factors. We used two broad approaches to create our models.

The first approach, called the holistic approach, focuses on a wide range of macroeconomic factors. This approach allows users to potentially consider scenarios based on variations of any of these variables. For example, one might consider a high inflation/low-interest rate scenario, a high GDP/high inflation scenario, or any other combination.

The second approach, called the targeted approach, focuses on a single specific variable along with its lags. This has the advantage of creating a parsimonious model, which is easier to understand and implement.

Holistic Model

The holistic model attempts to capture the macroeconomic factors that could affect loan prepayment speed. Inflationary pressure, macroeconomic outlook, and the interest rate environment are some of the macroeconomic factors that are generally expected to be relevant to BSL prepayments.

With this idea in mind, we assembled a large set of macroeconomic factors and tested them in combination with each other. Instead of testing all combinations of all transformations of the relevant variable pool, we tested combinations of the most important variables and avoided trying too many different transformations and combinations. The result is a model that includes several variables that are intuitive and logical.

The following variables are included in the model, along with an explanation of the economic reasoning for having them:

CPI (quarterly growth) –This variable captures the current quarter’s inflation rate. As such, it tells us about the current inflationary environment and provides a decent proxy for inflation expectations moving forward. Borrowers facing higher inflation expectations will be more inclined to find alternatives to prepayment (i.e. reinvesting in the business) and thus prepayments would be expected to decrease, all else equal.
S&P 500 (year-over-year growth) – As public equities markets are forward looking indicators of macroeconomic growth, the change in S&P valuations gives us a good indicator of how markets feel about macroeconomic prospects. When the S&P is improving, prepayments increase reflecting the fact that borrowers likely feel enough optimism to attempt to pay off more of their debts and/or raise equity financing to prepay debt.
High Yield Index Option-Adjusted Spread – The spread considered looks at yields of corporates with ratings of BB or less with respect to a spot Treasury curve. The index has a negative relationship with prepayments, all else equal. When spreads decrease, borrowers are less inclined to hold loans still tied to a higher spread from a previous high spread period. As such, they’re likely to prepay knowing that they have the option to get new financing under a more favorable spread.

In Exhibit 1 below, we see the model fit through historic data. In the earlier parts of the data, the sample of loans is not yet fully populated and consequently a bit more volatile from period to period. As such, the fit isn’t as strong. But from 2018 forwards, the model-fit is quite good and we can see that the model captures the major swings in prepayments that have occurred in response to the significant macroeconomic shifts that have occurred since 2018.

Exhibit 1: Macro Model Fit

Macro Model Fit - Quarterly Prepayment Rate

Targeted Model

While the holistic model captures a good deal of nuance regarding the various factors that could drive prepayment risk, the complexity creates some costs. Coefficients become harder to interpret as more variables enter the model.

Creating logically consistent alternative scenarios becomes harder as more variables must remain consistent with each other. As an alternative one could consider a simpler model that focuses on just one variable along with its lags. Fortunately, when one looks at the High Yield Option-Adjusted Spread, one finds such a variable.

Simply plotting the two variables against each shows a strong inverse relationship between spreads and prepayments. There’s also a straightforward and logical explanation. When spreads are lower, borrowers prefer to prepay and take advantage of lower spreads for refinancing. When spreads are higher, borrowers do not.

Exhibit 2: Spread vs Prepayment Rate

Spread vs Prepayment Rate - Quarterly Values

We can also consider lagged values of yield data, which points to an inverse relationship between spreads and prepayments. Lagged values are positively correlated with present prepayments. This can be explained by seeing current and previous spreads as both playing a role in driving prepayments.

If today’s spreads are low, but 6 months ago spreads were also low, then prepayments might not be as high as in an alternative situation where today’s spreads are low but 6 months ago spreads were extremely high. In the first case, borrowers likely took advantage of low spreads, but in the latter case, borrowers likely have high spread loans that they would be eager to refinance.

Exhibit 3: Target Model Fit

Scenario Analysis

Creating forecasts across scenarios is necessary for doing scenario analysis. To do so, we start with a simple baseline forecast for High Yield Spreads, that shows it steadily decreasing over the near term. For alternative scenarios, we simply take the forecast and bump them up and down by 2 standard deviations of the series’ historic values. With that straightforward scenario prepared, we can create prepayment forecasts for our portfolio to see the impacts of changing spreads.

We can see the results below in Exhibit 4. Higher spreads lead to lower prepayments, lower spreads lead to an increase in prepayments. Interestingly, because we use previous values of spreads in the model, the model inherently recovers towards the baseline. This makes sense intuitively. If spreads drop, borrowers would prepay and refinance to take advantage of new lower spreads.

But if spreads remain at that level, borrowers will eventually no longer need to keep refinancing. By the converse, when spreads rise that may initially create difficulty for prepaying, but as borrowers adjust to the higher spread environment, they may find themselves reverting to their more typical prepayment behavior.

Exhibit 4: Scenario Forecast

Out-of-sample Results

These models were developed in early 2023 with data only being available through 2022Q4. At the time of writing, both prepayment and macroeconomic data were available through 2023Q3, allowing us to evaluate the accuracy of our forecasts by comparing them to the actual data.

The results showed a notable divergence between forecasts and actuals for both models with the actual data remaining at very low levels while the forecasts increased. In the holistic model, the lowered spreads, reduced inflation rate, and S&P 500 gains all drive predictions upwards.

In the targeted model, we witnessed spreads increase in 2022, followed by a decrease in 2023. According to the model, that combination will lead to increasing prepayment rates.

To explain this divergence, we can consider the possibility that pessimistic expectations about the future state of the macroeconomy led borrowers to avoid prepayment. The series of bank failures in March 2023 led to serious concerns of a potential wider banking and economic crisis.

Beyond that, the continued interest rate hikes led to widespread concerns that the effort to beat back inflation might cause a recession. The volatile geopolitical environment further exacerbated these effects to increase market volatility and stress market sentiment. With these different perceived risks to the macroeconomy, borrowers would likely hesitate about prepaying even if the current macroeconomic data showed signs of improvement.

We can see evidence of forward-looking pessimism in a number of data sources. According to NABE, a majority of Economists surveyed in February 2023, expected a recession in the next 12 months. Furthermore, consumers showed similar pessimism regarding the future.

Within the Consumer Confidence Index, the Present Situation Index and Expectations Index diverged in recent data. The Present Situation Index recovered substantially in 2021 and has remained at a high level. Whereas expectations began dropping in 2022 and have recovered only slightly since then. However, to fully understand the impact of these perceptions on prepayment behavior, it’s important to examine business perceptions as well. After all, businesses are the actual borrowers in this context.

The OECD’s Business Confidence Index shows a similar pattern. Business Confidence peaks in early 2022 as it recovers from the COVID pandemic, but then begins declining from there. In early 2023, it bottoms out close to its pre-COVID level and remains at that low level.

Another frequently discussed forward looking indicator for recessions is the 10-year 2-year Treasury Spread. The indicator has predicted every recession between 1955 and 2018. The yield curve has been negative since July 2022, suggesting that markets are expecting a downturn in the new future.

Having considered an explanation for the forecast divergence, one can consider modifying the model to improve its performance going forward. Given the popularity of the 10-year 2-year Treasury spread as an indicator of recessions, we can consider using that in the model.

We take the holistic model consisting of S&P 500 growth, High Yield Spreads, and CPI growth. Both the S&P 500 growth rate and the 10-year 2-year spread are capturing future expectations of performance. So, we can try substituting the S&P 500 growth rate with the 10-year 2-year Treasury Spread.

When we evaluate the new model, we find that it does better in back-testing exercise for 2023 (as see in Exhibit 5), as well as in a rolling back-test exercise where we consider each of the previous years as potential holdout samples. Given that, the revised model seems to do better forecasting both history and recent data, we can consider using it as a champion model going forward.

Exhibit 5: Out-of-sample results for Revised Model

Conclusion

In this article, we have explored how macroeconomic factors drive prepayment risk in the BSL market and the importance of stress testing and scenario analysis in making informed investment decisions. Through our Risk Modeler Analytics platform, we presented two approaches for thinking about macroeconomic factors: 1) a more sophisticated approach that considers numerous macroeconomic factors and 2) a more straightforward approach that is easier to implement for scenario analysis.

We then reviewed the out-of-sample results and recent macroeconomic data. We found that incorporating 10-year 2-year Treasury Spreads as a factor in the model could improve the model’s out-of-sample forecasting results and have added that into a new model moving forward.

In conclusion, understanding how macroeconomic factors affect prepayment risk is crucial in evaluating BSL investments. By utilizing scenario analysis and macro-based models, investors can gain insights into borrower behavior and make informed decisions that drive analysis and decision-making to allow BSL managers to manage their portfolios and optimize their returns.

Fortunately, a holistic model that incorporates inflation, 10-2 Treasury Yield Spread, and high yield spread variables offers a powerful, intuitive, and effective model input to facilitate this important prepayment analysis. Stay tuned for the next prepayment analysis of loans issued by public capital market participants and retail lenders.

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Why stress testing and scenario analysis are vital in assessing pre-payment risk in broadly syndicated loans

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