In the face of declining interest rates, loans could remain as a source of strong, steady income as historically the loan market has managed to retain investor capital when rates decline.
We believe we are able to target attractive return potential relative to prior vintages, with materially less risk in the distressed credit market.
All-in yields in direct lending could remain well above historic levels and offer a compelling risk and return value proposition.
Over the last decade private credit markets have been one of the fastest growing segments in the asset management industry. As 2024 draws to a close, our experts have provided some market commentary on the next era of private credit. We are looking at some of the biggest opportunities, risks and key themes in the private credit space for 2025.
Kevin Eagan, Senior Portfolio Manager, Co-Head of Credit
In the year ahead, we expect another year of above average loan returns given a benign risk environment benefitting from lower inflation and interest rates. With the Federal Reserve pivoting to lower rates, it is worth revisiting the history of loan market flows during easing cycles.
The loan market tends to retain investor capital reasonably well as rates decline (outside of the exogenous shock levied by COVID), reflecting that loans offer more than simply a way to play rising rates. Lower rates tend to buttress loan issuer fundamentals as interest expense declines, mitigating risk of default and credit loss.
Moreover, assuming policy rates decline to the current fed funds futures-implied terminal rate of approximately 3.5%, the implied coupon would remain above the historical loan coupon average.
Thus, loans can remain a source of strong, steady income even in the face of declining interest rates.
Paul Triggiani, Head of Distressed Credit & Special Situations
As was the case in 2024, we believe 2025 is setting up favourably for our target small capitalisation distressed credit and special situations opportunity set. Importantly, we believe our pipeline is distinctly different and unique relative to the last quarter century. Almost half of our target market is burdened with greater cash interest expense than free cash flow generated by their operations. This imbalance is the product of leveraged buyouts capitalised in a zero-base rate environment which have been subsequently impacted by the COVID-19 pandemic, significant and global inflationary trends, and finally a significantly higher rate environment. Interestingly, many of these businesses are strategically and operationally sound, managed by excellent teams, with backing from highly respected sponsors.
Moreover, we are working with these companies both seeking to provide incremental liquidity on attractive terms in structurally advantaged, senior secured positions, as well as replace high cost, cash-pay debt, with creative capital solutions transactions that include payment-in-kind coupons, call protection with minimum return multiples, equity warrants, covenants, and governance protections. Companies are then able use this liquidity to accelerate growth, thereby allowing the private equity owners to monetise their investments.
Within these capital solutions opportunities, we believe we are able to target attractive return potential relative to prior vintages, with materially less risk.
Ron Kantowitz, Head of Private Debt
We remain constructive on the backdrop for direct lending in 2025 given meaningful macroeconomic and anticipated deployment tailwinds. Following its historic interest rate hiking cycle, the Fed pivoted to a more accommodative monetary policy in the third quarter of 2024. Market participants are not only expecting inflation to continue to moderate, but also for the economy to achieve a “soft landing”. This outcome bodes well for corporate borrowers who will benefit from lower interest expense burdens coupled with improved financial performance.
We also see a favorable setup for improved M&A volumes in 2025. Private equity firms are facing mounting pressure from their limited partners to generate liquidity as depressed M&A activity over the past 24 months has led to a dearth of transactions. Moderating financing costs and better visibility into economic conditions should support an uptick in volumes, which will in turn drive direct lending financing opportunities and deployment.
Lastly, we expect all-in yields in direct lending to remain well above historic levels and offer a compelling risk and return value proposition. Core middle market direct lending continues to prioritise asset selection, strong documentation and moderate leverage.
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The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
Data as at 18th November 2024.
This is marketing material and not financial advice. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication.
Views and opinions are based on current market conditions and are subject to change.
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