Micro View: How insurers need to think about private credit in the post-pandemic economy

Nathaniel Molinari, Senior Investment Analyst at AEGIS explains why private credit is positioned favorably despite the disruptions of COVID

Sara Benwellposted on Monday, June 28, 2021

Insurance Investor: David: How has private credit performed during the COVID health crisis and what are the lessons learned?

Nathaniel Molinari: If we are talking about corporate direct lending and private credit as a whole, I would say 2020 was the first substantial test since the Global Financial Crisis.

No one had necessarily underwritten a deal that included 100% closure like what we saw a year ago.  It became an all hands-on-deck situation. Much like the public markets, the private markets have come roaring back as well.

The strong performance can be attributed to strong management teams and the support by the private equity sponsors they work with.

"It became an all hands-on-deck situation"

Private lenders were able to keep covenants stronger and documents tighter leading into the pandemic, which helped the asset class work through the challenges seen in 2020.

The management teams stepped up to the plate, with their agility in responding to the crisis.  Additionally, a lot of these loans have interest rate floors, which has been a benefit with rates so low.

Every organization will have their own lessons learned. Similar to money centre banks, private credit saw a large onslaught of draws on their capital commitments during the same couple of weeks in March and April 2020.

"Private lenders were able to keep covenants stronger and documents tighter "

Similarly, we saw a high level of our capital calls all come in at the same time as the rest of our investment portfolio was negatively performing due to the COVID pandemic volatility.

We had plenty of liquidity and were able to manage through this situation, but we will certainly include this in our analysis going forward.

Insurance Investor: How durable is the market recovery, assuming there is a longer, drawn out default cycle?

Nate: Well we haven’t seen the default cycle quite like we had anticipated at this time a year ago. Private lenders were able to keep covenants stronger and documents tighter

In 2020 we saw business formation skyrocket. We have just seen quarterly reports from the banks, and bank lending by money centre banks has continued to decrease.

Those two trends are favourable for private credit.

Of course, a lot of these new businesses won’t be eligible and aren’t sponsor backed today, but that is a favourable trend and from an institutional investor standpoint in the next few years we are going to be able to participate in this new business formation.

"Private lenders were able to keep covenants stronger and documents tighter "

We believe the niche we participate in, which is sponsored finance, continues to have favourable trends.

Private equity recently reported it has close to 2 trillion dollars in dry gun powder, so looking 3-5 years on the horizon, looks favourable for private credit despite new entrants and lenders and competition in both public and private credit markets.

Managers who have continued to maintain their standards of credit underwriting and portfolio construction are going to be able to perform even if we have another turn to the negative on the economic side and if perhaps the default cycle does increase.

Insurance Investor: What have the effects of fiscal and monetary policies been on the asset class, particularly PPP lending and the lower middle market?

Nate: From the US perspective, the floodgates were opened in the last 12 months to help negate and dampen the effects of the pandemic.

Intervention by the Fed and the stimulus packages from congress have been positive for the majority of the economy.

Although many private equity firms did not take PPP funds, over 1,000 companies backed by private equity did.

"This government support has been meaningful and helped local and middle market companies weather the storm"

Of course, a lot of these new businesses won’t be eligible and aren’t sponsor backed today, but that is a favourable trend and from an institutional investor standpoint in the next few years we are going to be able to participate in this new business formation." 

This government support has been meaningful and helped local and middle market companies weather the storm on the front end of the pandemic and transition towards growth as we move closer to a new normalization.

Insurance Investor: How are investors protected from challenges faced by debtors, including the economic hurdles posed by the pandemic, the threat of rising interest rates, and possible liquidity risks?

Nate: The asset class is positioned favorably despite the disruptions of COVID. Market pricing structures have shown improvement from pre-pandemic levels and managers have been able to get better yield spreads, much to their benefit.

They have also been able to underwrite to lower leverage levels from pre-pandemic levels, thus providing greater loan to value cushion for lenders.

Lenders have been able to improve loan terms and covenant packages, which has provided more secure and defensive loan packages.

"The asset class is positioned favorably despite the disruptions of COVID"

Historically, the senior secured asset class has had higher recovery rates over the unsecured, subordinated or bank loan asset classes.

With private credit, the main takeaway is that post-pandemic, it has better covenants, better leverage levels, better pricing, and the history to back this up from a recovery standpoint.

All of these point towards a better defensive strategy which will protect us from any future headwinds.

 

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