Strategy note

Dare to dream part II—The time for private credit is now!

A new strategy note from Chief Market Strategist Troy Gayeski

Troy A. Gayeski
October 10, 2023 | 20 minute read

The opportunity set has improved

In our last strategy note, we discussed the hypothetical “dare-to-dream” macro scenario for private lending and multi-strategy funds, and how the now increased probability of a higher Fed Funds rate for longer—without suffering a potential hangover from a recession-driven default cycle—may benefit these types of strategies.

However, even without dare to dream fully materializing, the opportunity set for private lending strategies to generate more income and total return for longer has improved substantially. So, in this note, we will focus on both private senior secured commercial real estate and middle market corporate lending with a complimentary emphasis on non-commercial real estate (CRE) asset-based loans.

Private CRE and corporate loans: The potential to protect capital when markets get ugly

It’s an attractive time to be a private lender…as long as you have dry powder to take advantage of the opportunity!

As a reminder, private CRE and corporate loans were two of a handful of strategies that provided attractive absolute returns in 2022 when both equities and bonds were a complete train wreck. One of the key attributes of any alternative strategy is the potential to protect capital when markets get ugly. Posting mid-single digit returns—or better—when equities and bonds are simultaneously getting obliterated was even better than protecting capital (a true win for those that embraced noncorrelated return streams and democratized alternatives).

Both strategies are on track to generate even higher income and total return so far in 2023 (as we predicted in the year-end 2022 strategy note) while bonds continue to struggle—the Barclay’s Aggregate Bond Index (BAGG ) is down yet again in 2023.

Senior private lending strategies: A brighter outlook

The other point we made then and reiterate now is a few other strategies that performed well in 2022 had a much darker outlook going into 2023 (like equity REIT’s—bingo) and have an arguably darker outlook now going forward than coming into 2023. In contrast, the outlook for senior private lending strategies looks even brighter now than entering 2023 as headwinds have turned to tailwinds and the banking system goes into retreat.

Headwinds turn to tailwinds

The first reason senior private lending strategies are potentially looking strong are the headwinds that have turned into tailwinds. For the vast majority of the post-global financial crisis (GFC) era, most floating rate1 lending strategies fought two stiff headwinds for generating higher income and total return.

  • Fed funds rate: The Fed never hiked—then they barely hiked over four years—then, whoops, they cut by 75 bps, then the pandemic hit and (here we go again), the Fed cut rates back to zero and kept them there way too long. Clearly, this stiff headwind has turned into a powerful, sustained tailwind and has led to at least modest improvements in income and total return so far. 
  • Spreads and leverage: The second is less obvious but still critically important. In an environment where the Fed relentlessly printed money faster than nominal gross domestic product (GDP) grew, spreads were tighter and leverage levels were higher than they would have been otherwise. Now that the Fed has been withdrawing liquidity at a historic pace, spreads have widened (more income and total return) and/or leverage levels (loan-to-value (LTV), debt/EBITDA) have declined (less risk).

Who doesn’t like greater income and total return with less risk?

A banking system in retreat

The second reason the senior private lending strategies have a potentially positive outlook is the fact that the banking system is in retreat.

Even prior to the recent bank failures, the banking system was battening down the hatches and tightening lending standards in order to mitigate loan losses in the next recession. Since the bank failures, U.S. regional and community banks have taken risk aversion to a whole new level and have become far more reluctant to lend.

We had thought the great secular post-GFC deleveraging of the banking system was over but, boy, are we happy that we (and everyone else) were wrong. The impact is being felt all across banking.

  • Fleeing deposits: Deposits have been fleeing to money market funds and too big to fail banks. The U.S. banking system has lost around $800 billion in deposits since the recent failures which—at the U.S. banking system Q2 2023 loan-to-deposit ratio of 0.66—has reduced their ability to lend by approximately $528 billion. At the pre-pandemic loan-to-deposit ratio of 0.72, the reduction is an even more dramatic $576 billion.
  • Decline in asset values: Banks are still nursing book value declines in duration-sensitive assets due to higher interest rates on long duration2 assets. Hence, they have already eaten into their Tier 1 capital3 cushion prior to suffering any meaningful credit losses.
  • Little incentive to lend: The current inverted yield dramatically reduces the incentive for banks to lend. Which by the way is exactly the point of Fed policy in hiking rates so much and inverting the yield curve! Inverted yield curve → less lending → slower economic growth → lower inflation.
  • Regulation and capital cushions: Stiffer regulation and even greater capital cushions including longer-dated liabilities (as opposed to instantaneously liquid deposits) are coming fast—they are as inevitable as the tides, as the political class and the public are in no mood to bail out more banks.

An opportunity to selectively extend loans

This is not to say banks have stopped lending; they are just being far more cautious about extending new loans, rolling existing loans and in some cases are just selling off high quality assets to raise capital and liquidity. The best evidence of this is that bank loan growth has completely flatlined the past five months when it typically grows around the same level as nominal GDP.

As a reminder, banks are the largest lender by far to commercial real estate (61% or ~$3.4 trillion of a $5.6 trillion market) and community and regional banks have comprised approximately two-thirds of bank lending to CRE (~$2.3 trillion).

Additionally, banks have $2.76 trillion of commercial and industrial (corporate loans) on the books. Smaller banks (those that are smaller than the top 25 U.S. banks by assets) have over $700 billion of exposure to C&I loans. Too big to fail banks are in fine shape, but community and regional banks are struggling.

Thus, the opportunity to selectively extend loans is massive.

Liquidity vacuum

A liquidity vacuum is nirvana part II for private lenders with dry powder to lend. So how are senior private lenders taking advantage of the opportunity? Oh, let me count the ways…

CRE lending

(You want to be on the right side of the wealth transfer from owner/operator to lender).

The core strategy has always been to focus on short maturity (3-year loans with two 1-year extension options) for acquisition, development and transitional financing.

However, now that banks are hamstrung, commercial mortgage-backed securities (CMBS) issuance has slowed substantially, and many listed alternative lending strategies (mortgage REITs) are stepping back, a new opportunity has emerged to lend to borrowers on high quality/trophy properties as existing loan maturities come due.

The rolling loan opportunity set

From our perspective, a majority of the higher quality opportunities over the next several years may be providing financing to borrowers that need to roll their loans (aka the “rolling loan opportunity set”). Around $2.6 trillion of loans will have to be rolled in commercial real estate through 2027 so the opportunity set is vast. This has already led to trophy lodging and industrial loans at lower LTVs and wider spreads at a much higher base rate—Secured Overnight Financing Rate (SOFR).

Currently in CRE, the concept of the efficient frontier4 (meaning, if you want more return, you have to take more risk, and If you want less risk, you have to sacrifice return) has been turned upside down.

This is one of the only times I have seen this in my career (the other being the dark days of the GFC when debt securities were offering historical high yields/cash flow with substantial price appreciation through spread tightening).

Senior loans: Higher income and total return

Given the increase in lending rates, and the fact that most equity REIT’s cap rates are in the 4.5%–8% range, you can potentially enjoy higher income and total returns with less risk in senior loans (top of the capital structure) than at the bottom of the capital structure (equity). Let me repeat that: Higher income AND total return in senior loans than equity.

This opportunity won’t last forever as borrowing costs will eventually decline, and cap rates will continue to creep higher (either by additional price declines, or CRE prices not increasing in line with future net operating income growth, or a combination of both).

So, you have to “roll up the capital structure” and stay there for a while! I promise to let you know when it makes sense to roll back down to CRE equity.

Opportunities in CRE lending

Additionally, opportunities to buy loans directly from banks are beginning to materialize.

Some of the better opportunities in CRE lending that are present in both rolling loans, standard acquisition, development and transitional financing are the following:

  • Geographies: Places with strong population and income growth. Location, location, location.
  • Multifamily
  • Hospitality and lodging
  • Industrial and warehouse
  • Brick-and-mortar retail

Let’s take a look at these in greater depth.


Even though property owners are taking a short-term price hit as borrowing costs have climbed and cap rates are inevitably creeping higher (that may or may not yet be fully reflected in fund net asset values), the fundamentals for lenders still look strong given relatively tight supply, high occupancy levels and a continued lack of sufficient construction and supply of single-family homes.

On top of that, with home prices rebounding, homeowners are reluctant to sell because they don’t want to move from a 3% mortgage to a 7% mortgage.

Since home affordability has plunged to new all-time lows, the economic advantage to renting as opposed to buying is hovering around all-time highs (even higher than the pre-GFC housing bubble). Thus, forward rent growth is looking much rosier today than nine months ago (oh boy, this is going to complicate the Fed’s job taming inflation).

Hospitality and lodging

Travel and leisure activity has dramatically rebounded since the dark days of the pandemic and continues to boom. Additionally, travel and leisure should be much more resilient to an economic downturn than in the past since middle class to wealthy consumers are now prioritizing services over goods and vacations over a fifth flat-screen TV.

The opportunity for lending against trophy properties in coveted locations has rarely been better. Isn’t it ironic very few if any equity REIT’s prioritized lodging over multifamily and industrial during the past several years, and lodging is the only sector in CRE that has not declined in value the past 12 to 15 months? Well done, ladies and gentlemen.

Lastly, lodging continues to be a viable inflation hedge because rents reset daily as opposed to annually or over longer time periods.

Industrial and warehouse

Prices, LTVs and spreads became a little too frothy by the summer of 2021, driven by tight supply, secular demand, and some would say unrealistic expectations for continued price increases. Now that gravity has reasserted itself (not just on go-go growth managers), LTVs have come down and spreads have widened meaningfully.

Thus, this sector is back in favor from a lending perspective, far faster than one could have dreamed of as recently as 12 months ago. It’s go-time again for industrial lending!

Brick-and-mortar retail

After a long decade-plus purgatory where excess supply had to be purged, brick-and-mortar retail in the right locations has made a powerful recovery and has a bright outlook ahead. The opportunity to selectively lend at low LTVs and wide spreads should be better compared to the majority of the post-GFC period.

Office towers in trouble, but there could be hope

The one major sector that continues to be challenged is major metro office towers in locations suffering from population and business exodus, which continues to look like a replay of the slow-motion train wreck in brick-and-mortar retail over the last 10-plus years up until recently. That being said, it is encouraging to see green shoots even in troubled locations like San Francisco over the past three months as office leasing searches have climbed dramatically (if you are a San Francisco office tower owner, you may like AI even more than NVDIA shareholders).

And yet, despite the never-ending negative headlines over the past 12 months, the market is beginning to function again. Original owners are taking losses—in some cases total—with modest additional losses bleeding into the banking system, insurance companies, the CMBS market and listed mortgage REITs.

New buyers are stepping forward to transact at massive discounts to pre-pandemic values, at which point, the math of the property works to make money—even without substantial lease improvements.

The benefits of CRE lending

As a reminder, CRE lending is a ~$5.6 trillion asset class that has tremendous heterogeneity/diversity. The name of the game is continuing to optimize loans based on LTV, spread to SOFR, sector, geography and quality of borrower.

And with three-year average life loans, the ability to evolve a private CRE loan portfolio is an attractive attribute that most private strategies do not possess.

This being said, it’s not all peaches and cream in CRE lending—but certainly mostly!

Now if you are prone to always see the glass half empty (or 90% empty), there are a few risks and challenges to highlight. If you make your living originating CRE loans, you might be frustrated by the fact that acquisition and development originations have slowed substantially as CRE sellers grapple with lower prices than they would prefer to sell at, and buyers wait patiently for prices to come them.

Additionally, if you are a bank, insurance company or listed mortgage REIT with meaningful exposure to office towers in the wrong locations, you are probably sweating some degree of loan loss in the future. And generally, any lender would prefer to see the underlying asset they lent against in the past appreciating in value instead of declining in value.

However, there is never a “perfect” environment for any strategy and currently the pluses outweigh the minuses for senior CRE private lenders making hay while the sun is shines.

Corporate private lending: Vintage, vintage, vintage

In corporate private lending with an emphasis on asset-based lending (ABLs), if you have dry powder and a clean vintage portfolio, you are now like a kid in a candy store.

There are numerous key advantages to only beginning to originate loans late last year after spreads had widened and leverage levels had come down (LTV and debt/EBITDA).

  • Wider spreads: Lending at wider spreads locks in more income relative to tighter spreads over the life of the loan. 
  • Lower Leverage: Lower LTVs and debt/EBITDA ratios translate into less risk of both default and realized losses in the event of default. Who doesn’t like more income and total return with potentially lower risk?
  • A free look at more troubled industries, sectors and companies: Over the past four years now, corporate entities have been stressed by a pandemic, a high inflation/rate environment, a decline in real estate prices, structurally higher labor costs, stressed supply chains, lower (and then higher) commodity prices and more. No one could possibly foresee all of these various scenarios and defaults have already climbed a bit. The additional hindsight provided by a clean vintage relative to a 2021 vintage can help a lender avoid potential landmines.
  • No need to lend at terms anchored to yesterday’s rate: By Q3 of last year, potential debt service funding stresses had become apparent, so there is no need to lend at terms anchored to yesterday’s rate environment when it’s now clear rates will be higher for longer. Current loans are originated at healthy debt service coverage levels in today’s high rate environment.

If/when rates go back down, debt service costs should decline. If we enter a recession, you have more EBITDA cushion to avoid default since debt service costs are more manageable.

If you originated loans two years ago, and let your underwriting standards slip because of pressure to put money to work, and were not planning on higher rates for longer, your debt service coverage ratios (DSCRs) could already be in perilous territory. And heaven help you if we have a recession and the Fed only cuts to 3%.

Asset-backed loans

So much of the action and excitement in private lending now (and for the foreseeable future) is, and will continue to be in asset-backed loans—where loans are backed by various types of collateral above and beyond the cash flow of the corporate entity.

The two most intriguing opportunities now are bank deleveraging opportunities and bankruptcy probability reduction/prevention loans.

Bank deleveraging opportunities

By last October, regulators and risk officers at banks began to ramp up the pressure to improve credit quality in banks. At that point, banks began to pursue “regulatory relief” strategies again (a popular, long-term strategy pursued after the GFC and up until the pandemic).

During 2020 and 2021 (and even through Q2/Q3 of 2022) the President, Congress, the Fed, the Office of the Comptroller of the Currency (OCC) and the FDIC just wanted banks to get money out the door to support the economy. Thus, the regulatory relief strategy ceased to exist from March 2020 through September 2022.

By last October, regulatory relief strategies appeared to be a golden oldie coming back to private lenders for many years. However, since the recent bank failures, regulatory relief strategies have been completely leapfrogged by outright asset sales as banks aggressively reduce leverage. So, whether they’re auto, home improvement, RV, boat or credit card loans, it’s now a loan purchasing bonanza for private lenders (banks’ pain is private lenders’ gain).

For instance, a private lender can review a pool of auto loans—scrub them by FICO, income level, geographic region, manufacturer, etc.—and then buy the cleanest loans that meet the underwriting criteria at attractive prices and yields.

And this is not just a smaller than too big to fail opportunity. Even one of the too big to fail financial institutions has been very publicly selling off assets. I never thought we’d see this degree of motivated selling from banks ever again, but here we are.

Bankruptcy probability reduction/prevention loans

By Q3 of last year, almost every non-investment grade company in America began to go through the same exercise: If the U.S. economy enters a recession over the next several years, what steps can we take in advance to prevent or reduce the probability of bankruptcy and enhance current liquidity?

Due to the fact that over the past 10 years, covenants have basically been eliminated from syndicated bank loans, the corporate owners and management teams have the opportunity to strip out assets from the current capital structure and pledge these assets to a new, super senior lender.

Examples would be:

  • Inventory
  • Receivables
  • Property, plant and equipment

The new private lender can come in and, for example, provide loans at a reasonable 60%–70% advance rate on the collateral value, and then earn perhaps around S+625.

The management team and corporate owner (in many cases a private equity sponsor) win because they receive an injection of liquidity and reduce the probability of default in a recession. As a reminder, in a bankruptcy, equity value is typically erased, and management teams can be switched out—which is suboptimal to say the least for the equity owner and current management team. The private lender wins because they receive a healthy income stream, backed by tangible assets, and in some cases, the remaining balance sheet assets and cash flow of the company. This almost completely eliminates risk of loss in the event the company still goes bankrupt.

One could even argue (hey, I’m an optimist) that the current senior and junior lenders/debtholders win if the probability of bankruptcy is reduced by more than the future recovery rate is reduced on their asset in the event of a bankruptcy (since they no longer have claim to a select pool of assets).

It’s an entirely new phenomenon in capital markets and it’s not going away anytime soon.

Bank retrenchment: Old school, classic cash flow

Bank retrenchment provides more opportunity for old school, classic cash flow based loans to companies. It is highly unlikely spreads would have widened by around 63 bps and leverage levels would have come down sustainably if banks were lending as aggressively as they were in late 2021 and 2022.

Similar to Senior CRE loans, corporate private lending with an emphasis on ABLs is flipping the principles of the efficient frontier. As long as equities (public and private) are trapped in the galactic mean reversion, the potential for senior private debt to outperform equity is extremely high—with way less risk and volatility.

Conclusion: An improved opportunity for private lenders

It’s a great time to be a lender if you have dry powder to seize the opportunity.

The dare-to-dream scenario is only one part of the dramatically improved opportunity for private lenders. When one turns back to the efficient frontier, we are in a unique period when greater income AND total return can potentially be generated in the senior part of the capital structure than the equity part of the capital structure with—as always—dramatically less risk.

So, you know what you have to do: Roll up the capital structure in real estate and corporate balance sheets, fight inertia and don’t let paperwork or operational complexities deny you and your clients the ability to participate in the opportunity.

After all, the “time for private credit is now”—and the asset class is more democratized today than ever before!

Coming up next: Multi-strategy in a dare-to-dream scenario

The next strategy note will focus on how multi-strategy funds might benefit from the dare-to-dream scenario and focus on timely investment themes within multi-strategy investing.

Investing in alternatives is different than investing in traditional investments such as stocks and bonds. Alternatives tend to be illiquid and highly specialized. In the context of alternative investments, higher returns may be accompanied by increased risk and, like any investment, the possibility of an investment loss. Investments made in alternatives may be less liquid and harder to value than investments made in large, publicly traded corporations. When building a portfolio that includes alternative investments, financial professionals and their investors should first consider an individual’s financial objectives. Investment constraints such as risk tolerance, liquidity needs and investment time horizon should be determined.

  • Floating rate: A floating interest rate is one that changes periodically; their interest rates adjust or “float” as market interest rates rise or fall. Therefore, their value tends to be less impacted by changing interest rates than traditional fixed rate investments such as investment grade and high yield corporate bonds.

  • Duration: A measure of a bond price’s sensitivity to changes in interest rates. Given the inverse relationship between bond yields and prices, a bond with a longer duration should theoretically experience a larger price decline when rates rise or increase than a bond with shorter duration.

  • Tier 1 capital: Tier 1 capital refers to the core capital held in a bank’s reserves and is used to fund business activities for the bank’s clients. It includes common stock, as well as disclosed reserves and certain other assets.

  • The efficient frontier: The efficient frontier is the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are sub-optimal because they do not provide enough return for the level of risk. Portfolios that cluster to the right of the efficient frontier are sub-optimal because they have a higher level of risk for the defined rate of return.

This information is educational in nature and does not constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment. FS Investments is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All views, opinions and positions expressed herein are that of the author and do not necessarily reflect the views, opinions or positions of FS Investments. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. FS Investments does not provide legal or tax advice and the information herein should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact any investment result. FS Investments cannot guarantee that the information herein is accurate, complete, or timely. FS Investments makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.

Any projections, forecasts and estimates contained herein are based upon certain assumptions that the author considers reasonable. Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the projections will not materialize or will vary significantly from actual results. The inclusion of projections herein should not be regarded as a representation or guarantee regarding the reliability, accuracy or completeness of the information contained herein, and neither FS Investments nor the author are under any obligation to update or keep current such information.

All investing is subject to risk, including the possible loss of the money you invest.

Troy A. Gayeski, CFA

Chief Market Strategist

Search our site