Prudent Execution in Private Credit is Key for 2024
Prudent Execution in Private Credit is Key for 2024
Private credit benefited from higher interest rates in 2023, thanks in part to the floating-rate nature of the asset class. This year, even with the turn in the interest rate cycle and with rates expected to move lower, “the opportunity set continues to be very attractive,” said Greg Olafson, global head of private credit at Goldman Sachs. Institutional investors should still expect double-digit returns, and while returns could be slightly lower than last year, they could be attractive on a risk-adjusted basis, he said.
Achieving those returns, however, “will come down to the opportunity to deploy capital and to have [access to] the right client franchise. As we look ahead, we see a lot of opportunity to lend to high-quality companies,” Olafson said, particularly for experienced private credit managers deploying capital through robust deal pipelines with private equity sponsors.
Ongoing pressures
Following the Federal Reserve’s recent rate increases, the higher cost of debt has put pressure on borrowers, making some workout situations — when a borrower defaults and the loan terms are renegotiated — inevitable. “As companies that borrowed in the low-rate environment run up against their maturities and their rate hedges, their cost of debt will reset higher,” Olafson said. That could create pressure on companies that are not growing enough or driving sufficient revenue to offset the higher costs, and ripple effects could then inject stress into the market.
But those situations are likely to be on a case-by-case basis — private credit is not facing systemic risk from higher rates, he said. Whether it’s the PE-backed sponsors or the private credit managers, the asset class has “very sophisticated practitioners who have flexible mandates, and they can work through [challenges in] the portfolio in a constructive way, provided there is a sound business reason for extending that maturity, providing more capital or amending terms.” Private credit lenders, moreover, have more control and flexibility over key factors, such as duration, covenants and amortization payments. “That is a very important aspect of private credit. [The borrower] works with the lender.”
The higher cost of debt for borrowers as well as investor uncertainty around valuation price discovery last year both contributed to lower transaction volumes, Olafson noted. But with the resilient U.S. consumer and low unemployment underpinning strength in the economy, the Goldman Sachs Asset Management private credit team expects M&A volume to be higher this year. “The cost of debt coming down a bit helps, and also the [valuation] uncertainty is attenuating a bit,” he noted. Deal activity picked up in the third quarter last year, and “in our transaction volumes in our credit business, Q4 was far and away the strongest quarter of the year,” he added. “We see that continuing in the new year.”
Follow the track record
While the potential for increased deal flow is good news for private credit investors, the challenge is finding a hands-on manager who has a track record of access to quality deal flow and has worked through credit situations across differentiated market cycles. That’s even more true today in a more crowded private credit industry, where credit providers from other market segments have come in with a more lax view on deal terms to gain entry, Olafson said.
“You should be very focused on the prudence, expertise and long track record of who you’re working with. Look at their access to quality deal flow, because the fact is that many of these deals price the same: The terms are not that different, and terms will ebb and flow based on demand and supply,” Olafson said.
Private credit will continue to win over corporate borrowers, he said. “One might argue that the private credit solution is a superior solution because you’re dealing with your direct lender, who can provide certainty and flexibility and — now — the size that’s equivalent to what the public markets could historically deliver.” But “at the end of the day, it all comes down to credit underwriting standards, and the most important determinant of that is the quality of the business you lend to,” Olafson said.
Labor-intensive business
“It’s a labor-intensive business,” he said. “These are directly originated, directly underwritten and directly negotiated deals that require resources and people.”
A private credit manager needs to be active and engaged with its portfolio companies. It requires both resources and experience to navigate through any complex situations that could arise as companies respond to shifting market conditions. “You need to be able to think like an owner,” Olafson said. Goldman’s private credit team, he pointed out, works with the firm’s PE team and value accelerator team that helps enhance the value of its portfolio businesses.
Private credit managers are offering more sophisticated terms to borrowers, with hybrid solutions being active in the second half of 2023 and likely to continue over the next two years, he said. These are for situations where “these are good companies, but their growth may be a little behind plan, which means that their debt is maturing before the owner is ready to sell. They may need to add some new capital to grow [the business] further,” Olafson explained. Potential hybrid solutions could include extending maturity, a structural financing to bring in more capital, a secondary offering or a strategic sale by the PE owner.
Sectors to watch
Two sectors with potential for opportunity in 2024 are health care and software, both of which have exhibited strong growth and have seen a lot of PE-backed activity over the past few years.
Health care is a fundamentally sound industry, which is one reason why PE managers are drawn to providing debt financing to health-care organizations. “They have strong demographics, strong innovation, significant barriers to entry and they’re capital efficient,” Olafson said. But the health-care industry, in particular, faces tight labor conditions, which can drive wage inflation.
Software, also a fundamentally sound industry with a solid and recurring customer base, could find that an economic slowdown would induce corporate customers to reduce spending, or at least not increase it. That would make it harder for these companies to refinance or raise new capital at reasonable rates. “It’s, perhaps, in disappointing growth where the risk lies,” Olafson said. In both health care and software, “there’ll be a lot of opportunities, and there may be some challenges as well,” he added.
The secular, long-term transition away from fossil fuels to renewable energy sources is an area ripe for private credit investment. This transition, which is still in its early stages, will require heavy amounts of investment, both equity and debt capital. “Innovation around energy efficiency, the energy transition and decarbonization is an opportunity that will require a lot of capital, and there will be opportunities to lend and invest against that,” Olafson said.
Focus on execution
Regardless of how the economy performs in 2024, companies in health care, software, energy and other segments will continue to need fresh capital and refinance existing capital, providing private credit managers with deployment opportunities throughout the year.
Today “it’s all about the quality of the transaction: The A-credit book is built one deal at a time,” Olafson said. In a more complex market environment that needs the steady hand of an experienced private credit manager, “we have to ensure that in this somewhat euphoric moment for private credit, we don’t lose sight of the fact that it’s a business rooted in prudence, in execution, in application, in diligence.”
