Calling all LPs! Thanks again for joining me (John Bailey, Co-Founder at OneFund) for another edition of Capital Call. A bi-weekly private equity newsletter from LPs for LPs. 

First off, as you’ve probably noticed we’ve made the switch over to Beehiiv!

We’ve been meaning to make the switch for some time. Honestly, Beehiiv is a more intuitive and beautiful product compared to Substack. It has features that will help take this newsletter to the next level and provide an even better reading experience for our community.

As always, our mission with Capital Call is to deliver top-notch insights and updates from the private markets tailored to what matters for LPs. 

This week we will be looking at: 

• Q3’s Evolving Credit Environment from the Lens of Sponsors and Lenders

• Fundraising updates and VC/PE reports

• GP Perspectives from Dan Rasmussen & Chris James 

Q3’s Exit Slump Delays Recovery

Today’s credit markets present a mixed bag.

According to analysis performed by Oaktree, Q3’s credit fundamentals remain strong despite high interest rates and slow earnings growth. 

Debt-to-EBITDA ratios for U.S. leveraged credit were around 4.0x on average at the end of Q2 2023, down from a high of 6.5x in Q4 2020, and interest coverage ratios have only deteriorated slightly. 

Averages appear strong, but Oaktree warns of long-tail risk here. A six-foot-tall man can drown crossing a stream that is five feet deep on average.

In this week’s capital call, I’ll dive into the state of today’s credit markets from the lens of both private credit GPs and PE sponsors, highlighting insights most relevant to LPs. 

The Divergence between High Yield Bonds and Leveraged Loans

First of all, high-yield bonds and leveraged loans are crucial to PE acquisitions as they typically make up the debt structure in an LBO. Leveraged loans are distinct from high-yield bonds as bank loans usually make up senior debt tranches, while bonds are more junior in the capital structure. Bank debt is also usually cheaper but with more restrictive covenants.

The quality gap between high-yield bonds and leveraged loans has widened significantly in the U.S., primarily due to interest rate hikes and economic headwinds. High-yield bonds have risen significantly in quality recently while leveraged loans are entering concerning territory.

Today, nearly 50% of high-yield bonds are rated BB or higher, nearing a ten-year peak, while only 30% of leveraged loans are rated BB and higher. As seen in the figure above, 65% of leveraged loans are now B-rated and below as the ratio of downgrades to upgrades in the loan market has risen to nearly two to one.

The divergence between these markets is driven by two factors. First, leveraged loans have gained significant popularity in financing LBOs, especially for highly leveraged industries such as healthcare and tech. Second, leveraged loans are typically floating-rate instruments, unlike bonds. As a result, GP financing with loans has seen a roughly 50% increase in interest expense over the last year combined with slowing EBITDA growth whereas bond issuers have largely been unscathed.

These overleveraged, interest-rate-sensitive borrowers could struggle servicing their debt as 62% of borrowers are predicted to see interest coverage ratios fall below one by the end of 2023. Oaktree forecasts higher-for-longer interest rates, leading to higher default rates in the leveraged loan market even if a recession is avoided.

Opportunities for Private Credit GPs

Private credit funds have expanded rapidly in 2023, and Oaktree predicts further growth from strong tailwinds. As an LP I would be a bit wary of this. Just because more capital is flowing into an asset class, that doesn’t mean that returns will flow back to LPs. Often it’s the opposite as more dollars are chasing the same set of deals.

We’re seeing demand for private debt financing increasing since sponsor-backed M&A activity has risen since September. In addition, re-financings are expected to grow significantly as an estimated 40% of the direct lending market is maturing in 2024-25, as seen below.

A second tailwind is that private lenders will continue to gain market share in large-cap financings as bank lending has remained muted in this market. This is due to a combination of banks suffering meaningful losses on LBO debt commitments, and the syndicated loan market becoming less reliable.

So how should LPs looking to gain exposure to private credit navigate the landscape? First, they should recognize that what distinguishes this environment from the past is debt markets have grown so large that if the annual default rates for U.S. leveraged loans and high-yield bonds were to remain below their recessionary averages and only rise to long-term averages, they would still result in a default wave that could rival the GFC or the dot-com crash. Essentially, be hesitant. I worry a lot of people are going to get burned.

This would, however, significantly increase opportunities for distressed debt investors and allow skilled credit GPs to distinguish themselves through risk monitoring.

Overall, LPs looking for private credit investments shouldn’t rush to invest broadly in the space, but rather conduct detailed diligence to make higher conviction investments in the GPs with the best risk frameworks.

Implications for Buyout Private Equity

Traditional buyout PE will continue feeling some of these macroeconomic difficulties but for how long remains to be determined. Recent LBOs financed with private credit have seen lender-friendly terms, where senior leverage only averaged 3.5x EBITDA and average equity contribution from sponsors has grown to 60%.

LPs should understand that while these terms make deals harder to execute, those that were completed recently have strong credit fundamentals and are at little risk of default. Instead, risk is highly concentrated around deals done before 2022 and LPs should ensure GPs are actively monitoring deteriorating credit scenarios.

Essentially, I’m more worried about LBOs made in 2021 when the market was hot than deals made now when the market is cooler. I would rather be in the 2023 LBO vintage.

Updates from Across the Ecosystem

Fundraising

📈 Carlyle Closes Flagship Fund VIII Under Target amid Industry Slump

📈 Trivest Wraps up Recognition Fund at $1.3bn

📈 Brynwood Partners Raises Ninth fund at $750m

Reports

🔬 Goldman Sachs: Unlocking the AI Supercycle

🔬 Pitchbook: Q3 2023 US VC Valuations Report

🔬 KKR: How We’re Assessing Relative Value in Leveraged Credit 

GP perspectives:

Dan Rasmussen (Founder, Verdad Advisers)

Dan Rasmussen, the founder and CIO of Verdad Advisers, shares an interesting valuation insight where he believes exit valuation should be 12x EBITDA plus or minus 60% of its premium or discount to that multiple. This formula is derived from taking the long-term average EV/EBITDA and applying a regression to predict three-year forward multiples. This results in 3Y FWD EV/EBITDA Multiple = 11.72 +  0.61 x (EV Multiple – Cumulative Avg. Median Multiple), which can be simplified to 12x + 0.6 x (Current Multiple - 12).

Though we believe this framework is too broad to underwrite investments with, it can prove to be a useful sanity check based on historical data.

Chris James (COO, Blackstone Tactical Opportunities)

Chris James, COO of Blackstone’s Tactical Opportunities team, emphasizes organic growth in today’s market and the end of financial engineering to generate value. He states you can no longer acquire a company, improve its capital structure, and realize value upon exit as you could have done years ago. This is due to the rapid rise of interest rates as well as the heightened competitiveness of the PE industry, requiring operational expertise to outcompete among GPs.

In addition, he predicts digital infrastructure, e-commerce, and life sciences to be key markets of focus for today due to their ability to grow faster than inflation and GDP while also having the resiliency to prosper in today’s challenging environment. 

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