Private credit: Opportunities to seize and risks to avoid

Private corporate loans and CRE lending: Attractive absolute returns in 2022

Private corporate loans and commercial real estate lending were two of a handful of strategies that provided attractive absolute returns in 2022—when both equities and bonds were a complete trainwreck.

One of the key attributes of any alternative strategy is the potential to preserve capital when markets get ugly. The fact that private corporate loans and commercial real estate lending were posting mid-single-digit returns when equities and bonds were simultaneously getting obliterated was even better than protecting capital, and a true win for those that embraced noncorrelated/low beta return streams. Sure, neither strategy has had as much upside as U.S. equities since equity markets bottomed in October of 2022, but they have continued to outperform real estate equity, fixed income (bonds) and cash by a wide margin over that same time period.

And let’s not forget the major theme of this year: Putting cash to work in strategies where you can potentially increase income and total return without taking uncomfortable levels of risk.

---

Corporate private lending and asset based loans: Opportunities to seize and risks to shun

If you have dry powder, a robust asset-based loan (ABL) platform, the ability to source bankruptcy probability reduction debtor-in-possession (DIP) ABLs and assets/loans directly from banks—and the ability to provide platform financing to specialty lenders—then you have been oscillating between nirvana and being a kid in a candy store for the past 21 months. That situation looks likely to continue for at least the next several years.

So, let’s start by discussing asset-backed loans.

Much of the action and excitement in private lending now, and for the foreseeable future, has been 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 three most potentially intriguing opportunities in this space are currently 1) bank deleveraging opportunities, 2) bankruptcy probability reduction DIP ABLs and 3) forward flow asset-based finance.

Opportunity 1: Bank deleveraging opportunities

Because of the macro trends we discussed in the previous strategy note, banks and financial institutions have been in “deleveraging mode” since early last year—driven by a desire to increase liquidity, “rebalance” their loan exposures or to clean up balance sheets prior to a merger. Whether the loans are auto, home improvement, RV, student, credit card, etc., this situation has been (and continues to be) a loan purchasing bonanza for private lenders. For instance, private lenders have been able to review a pool of auto loans, scrub them (by FICO, income level, geographic region, manufacturer, etc.), and buy the cleanest loans that meet the underwriting criteria; purchasing them at attractive prices and yields from a deleveraging bank.

Opportunity 2: Bankruptcy probability reduction DIP ABLs

By Q3 of 2022, almost every noninvestment-grade company in America began to go through the same exercise: If the U.S. economy were to enter a recession over the next several years, what steps could they 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 now have the opportunity to strip out assets from the current capital structure and pledge those assets to a new super senior lender. These assets could be inventory, receivables, property, plant, equipment, etc.

Here’s a hypothetical example of how a DIP ABL like this might work. 

The theoretical new private lender would come in and provide loans at a reasonable, say, 60%–70% advance rate on the collateral value and earn around S+450 to 625. Then, this is how some key players in this transaction might fair.

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

This is an entirely new phenomenon that began in early 2023 and will hopefully not go away any time soon. Interestingly enough, for about a 10-week period earlier this year, the flow for bank deleveraging and bankruptcy probability reduction DIP ABLs had temporarily dried up. At that time, I started to get a little bummed out these opportunities had faded away into the sunset. Fortunately, they have now come back strong.

Opportunity 3: Forward flow asset-based finance

We all know markets are cyclical and investors’ memories can be short. Over time, various financing markets in the U.S. have enjoyed booms and busts (for example, think of residential housing pre-Global Financial Crisis, or subprime autos more recently).

The booms come when recent and historical experience convinces lenders that losses will always be modest and that it’s OK to receive a lower yield because you have to put money to work—at which time, everything looks sunny, which leads to more and more capital flooding in.

The busts come when underwriting assumptions get mugged by a less sunny reality. That’s when losses start to accumulate, and capital flees.

Typically, the most attractive credit and/or lending opportunities arise after the bust, when you can lend at higher yields with tighter underwriting standards and lower risk of loss (that’s the whole concept of more income and total return with less risk again!). Without getting into too much detail, suffice it to say we have seen—and continue to see—a select set of recent opportunities like this that offer outstanding absolute and risk-adjusted returns.

For example, because subprime auto loans did so well relative to housing through the Global Financial Crisis, more and more lenders entered that market. Then we had the acute stages of the pandemic, which gave everyone quite a scare, but have no fear: Fiscal stimulus/transfer payments, the Fed and a more rapid economic recovery than expected occurred and the beat went on. And then here came an inflation surge and dramatically higher interest rates—which hit subprime borrowers far more dramatically than prime borrowers initially—which then started to drive losses in excess of income. To add insult to injury, used car prices cratered (after the initial post-pandemic spike), which was kind of a bummer for one’s recovery rate assumptions.

So, it hasn’t been pretty there for a while. Let’s be polite and just say late 2020, 2021 and early 2022 subprime auto vintage performance has been “below target,” which is a euphemism for “losing money.”

But you know what, that recent pain has now caused many lenders to run for the hills. Capital has fled, much tighter underwriting standards and greater structural protections have been implemented, used car prices are almost back to the inflation-adjusted long-term average trend line, and the Fed is about to bring some modest interest rate relief with recession risk still low. One of the main ways a private lender can potentially add alpha for investors is to step into a market opportunity and provide liquidity while others are vacating the premises because of poor timing and flawed assumptions. That’s because the pricing and risk are great after tightening underwriting standards and increasing structural protections, and the asset value that is backing the loan is close to or has reached a bottom.

The more of these opportunities we find, the merrier I’ll continue to be!

Additionally, I understand whenever someone hears the term “subprime” next to any type of financial service industry term, it can potentially (and naturally) cause a slight bit of anxiety. Remember, the key cause of the losses from subprime mortgages were the flawed assumptions that home prices never go down and that the last thing borrowers will default on will be their home mortgage (as opposed to credit card debt, student loans, auto loan, etc.). Also, the income from subprime mortgage loans was relatively low, and the loan-to-value (LTVs) could often be above 100%. So, with little income to start, and home prices dropping by over 30%, which, in turn, led to borrowers handing over the keys to lenders, well, suffice it say losses to lenders were higher than forecast.

However, when you’re lending at 21.3% on an asset that has historically had full cycle 34% recoveries after max pain has been fully priced, you can tolerate a lot of defaults without suffering any loss at all. In fact, if conservative full cycle default assumptions are approximately 11% per annum (in good times, lower; in rougher times, higher), and recovery rate assumptions are 34% (in good times, higher; in rougher times, lower), the loss adjusted yield of the loan pools should be approximately 12.8%. 

Another interesting example of forward-flow–based asset finance would be the lease-back sales of model homes to major U.S. homebuilding companies. With modest home price appreciation as a base case, and relatively high lease rates on the owned asset (the model home), attractive income levels can be earned without risk of loss in pretty dire housing market scenarios. This opportunity is presenting itself because of (you guessed it) banks pulling back from construction loans to everyone—including major homebuilders—at a time when our population, economy and housing demand are all still growing. This creates the natural motivation for major homebuilders to free up precious capital through leasebacks to do what they do best: Build homes.

Construction loans on one- to four-family homes

Source: CBRE as of June 30, 2024, latest data available. Chart shows average loan origination by lender type during the first half of 2023 and 2024.

The ability to potentially generate higher returns with less risk in ABLs vs. private corporate loans is rare. Typically, you receive slightly lower return for meaningfully less risk (that pesky efficient frontier¹ almost always asserts itself over time). However, in the recent past (and probably for the next year or so, though potentially longer), you have the chance to potentially achieve at least slightly higher returns in ABLs, with meaningfully less risk—once again, turning the efficient frontier upside down. And that’s an opportunity that should likely be seized with both hands (and maybe both feet too!). 

---

The opportunities of a clean vintage

I cannot emphasize enough the importance of investing in clean vintage private middle market corporate lending with a complimentary focus on asset-based loans versus investment vehicles with a large percentage of loans originated in late 2020, 2021 and 2022. If you did not start originating loans for an investor portfolio until late 2022 (through both skill and luck), you have a huge strategic advantage in terms of risk/reward for the foreseeable future. Vintages of late 2022–2023 represent a more conducive lending environment, offering the potential for wider spreads and more opportunities to achieve lower LTVs and EBITDA.

By waiting, you received free looks at multiple stress points in the U.S. economy and capital markets. You had the opportunity to assess a pandemic, a high inflation environment (abruptly followed by a dramatic increase in interest rates and a tightening² of financial conditions), a decline in real estate prices, structurally higher labor costs, stressed supply chains, lower—and then higher—commodity prices and more.

Additionally, some industries, sectors and corporate entities have also been stressed by irregular abrupt changes in industry revenue projections (here’s looking at you, Medicare reimbursements). Ah, how fast a sound, recurring revenue and EBITDA technology loan can go from attractive to…less attractive…as a result of equity subordination value implosion, or a brutal reminder of the folly of doing longer maturity revenue loans within a lower risk lending portfolio.

No one, including yours truly, could possibly have foreseen all of these various scenarios unfolding, which has already led to an increase in defaults and nonaccruals from older vintage loans. The additional hindsight provided by a clean vintage relative to a late 2020, 2021 and early 2022 vintage can help a lender avoid potential landmines. Remember, in credit, it’s always about extracting your income and minimizing losses. It’s not about hitting doubles, triples, homeruns or the occasional grand slam to drive performance (like it is in private equity or venture capital).

And obviously, if you originated a substantial portion of your portfolio in the wider spread environment of October 2022 through June 2023, you have been able to lock in more income relative to tighter spreads over the life of the loan.

Lending at lower LTVs and debt/EBITDA locks in less risk over the life of the loan. (Again, who doesn’t like more income and total return with less risk?) By Q3 of 2022, potential debt service funding stresses had become apparent, so there was (and still is) no need to lend at terms anchored to yesterday’s rate environment when we’ve been in a higher-for-longer rate environment for quite some time.

Even with Fed cuts on the way, we will continue to be in a higher rate environment as far as the eye can see relative to the post-Global Financial Crisis period up until early 2022 (think new neutral rate of 3% vs. 0% for almost 15 years).

In today’s high rate environment, current loans are originated at healthy debt service coverage levels. As rates start to go back down soon, debt service coverage ratios (DSCRs) should go even higher—even without future EBITDA growth. If we unexpectedly enter a recession, you have more EBITDA cushion to avoid default since debt service costs are more manageable. If you originated the majority of your loans in late 2020, 2021 and early 2022 for instance, (and let your underwriting standards slip because of pressure to put money to work amidst fierce competition from banks and were not planning on higher rates for longer), your DSCRs could still be uncomfortably low even after continued economic growth. And heaven help you if we have a recession and the Fed only cuts the front end to 3%.

Broad and deep lending platform

What can often be lost in the shuffle of the complexity within any private strategy, including private lending, is the importance of having a broad and deep origination platform that’s been humming along for quite some time.

If you have been comfortably putting $10 to $15 billion to work per annum for a while, putting another $2 to $3 billion to work per annum isn’t necessarily a rounding error (I don’t want all of the incremental hard work done by seasoned loan originators to be diminished), but it’s certainly a readily achievable task. If you have been putting $1 billion or so to work for quite some time, and then suddenly you have to start putting $2 to $3 billion to work, it can force an investment team to make a very difficult choice. Continue to either prudently put the capital to work and live with a lower-than-targeted or expected distribution rate (which is the right answer, by the way) or to buy much more volatile, covenant-less syndicated bank debt to maintain a targeted or expected distribution rate.

This is not to say a private lending strategy should never opportunistically target syndicated bank debt as a tactical investment (heck, if bank debt traded down to 60 or 70 cents on the dollar, it would almost be a breach of fiduciary duty not to at least nibble opportunistically) or use it as a small portfolio percentage to manage liabilities once the strategy reaches equilibrium with inflows vs. outflows. However, if you make it 20% of your portfolio because you can’t put money to work and are not willing to live with a lower distribution level, then you are introducing material mark-to-market risk—and increased risk of default-driven realized loss. 

Risks to avoid in corporate private lending and asset-based loans

So then what are the risks to avoid in corporate private lending and asset-based loans?

• Bad vintage: This is pretty self-explanatory given the discussion before. If the bulk of your loans were deployed in late 2020, 2021 and 2022, you just have less income and total return potential, and more risk from future defaults and realized loss.
• Inability to originate ABL: Look, if all you can (or will) do in your strategy is private corporate loans, you are clearly going to miss out on the current potential opportunity for higher return and lower risk ABL present in the marketplace today: Turning the efficient frontier upside down.
• Too small of a platform to put money to work: This has forced some into syndicated bank debt. As we discuss above, I would be careful of any private lending strategy that has ever had to meaningfully ramp syndicated bank debt in order to maintain their distribution.
• Remaining large exposure to syndicated bank debt: Progress has been made across the industry from the early Q1 2022 highs in exposure, but more than 5% exposure in tradable bank debt could move the needle of future risk/return.
• DSCRs of 1 to 1.2: Similarly, progress has been made across the industry from the recent lows in DSCRs (since continued EBITDA growth in an expanding economy eventually increases DSCRs to less frightening levels). But a 1–1.2 range indicates there is little room for error in either the economy, the sector/industry or in the company before default risk rises substantially.
• Revenue loans: Avoid them altogether. That is, unless they come with increased structural protections like short-dated customer acquisition loans with high revenue multiples on borrowed or invested dollars, or if you can be certain the equity value beneath your loan is conservatively marked.

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.