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Special Edition: Stress Builds in Private Credit | Schroders' Risk Strategy
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Welcome. In this special edition, WSJ Pro explores the growing array of funds, deals and people gravitating to the private-credit strategy. We send out this credit-focused newsletter every two weeks, pulling together recent news and analysis from WSJ Pro and other Dow Jones brands.
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Stress in the private-credit market is building despite default rates rising only modestly in the past two years, according to JPMorgan Chase’s asset management group.
Interest coverage ratios, a common indicator of borrower stress that measures earnings against debt costs, have deteriorated as interest rates climbed to a multidecade high in August 2023, said the report published April 15. Lower coverage ratios indicate greater difficulty paying debt interest.
A rapid expansion of the market for nonbank loans since the financial crisis ended in 2009 has drawn in major private-fund managers. The increasingly crowded private-credit market has led some fund sponsors to take on riskier borrowers as they chase higher returns and try to differentiate themselves, according to participants in the market.
“The ability of weaker credits to obtain financing will likely lead to stressed and distressed situations arising at a more consistent pace—particularly in a higher-rate environment,” the authors said in the JPMorgan report.
Default rates remain below levels seen at the height of the financial crisis in 2008 and in its aftermath and again during the pandemic year of 2020, according to the report. But the effects of the Federal Reserve’s tightening policy, pushing short-term borrowing costs to 5.33% last year, the highest since 2001, is expected to push more borrowers over the edge.
“Every time you see a sharp increase in the Fed funds rate, within a year or two, you get a spike in defaults,” said Jared Gross, head of the asset management group’s institutional portfolio strategy.
The default rate for U.S. speculative-grade corporate debt is expected to reach 4.7% by December, according to research from S&P Global Ratings. The rate hovered below 3% nearly two years ago, before the Fed began pushing rates up from near zero to combat surging inflation.
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More below: Franklin Templeton has quietly become a major force in private markets. Brightwood Capital faces a legal challenge over a roughly $253 million continuation-fund deal. Blackstone delivered higher-than-expected earnings as it raked in money from its credit strategies.
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Schroders' Co-Head of Private Debt Discusses Risk Strategy
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Michelle Russell-Dowe, Schroders' co-head of Private Debt and Credit Alternatives, shares her views on risk factors in the private-credit market and how they impact her decision-making going forward. Schoders's PDCA business was formed last year and oversees at least $30 billion in assets under management with more than 100 investment professionals. Responses have been edited for clarity.
WSJ: How has the current risk environment impacted your investment approach?
Russell-Dowe: The current risk environment is a particularly challenging environment. While there has been more volatility, much of that volatility has been driven by interest rates. From an investment return perspective, private debt, and private credit, like other floating-rate instruments, fared better from a return/income perspective with the rise in interest rates. But the higher interest expense also creates more potential for strain, particularly for borrowers who cannot grow their income or earnings to cover the higher expense. This is a market where the main risk is idiosyncratic. This means we need to be even more focused on analysis and fundamentals.
At the same time, the U.S. exceptionalism has created a bit of a buyers panic with many market participants seeking more risk, even as risk premiums are at near historically tight levels. Yields are high, but risk compensation is low. This creates a market where investors stretch for yield, where issuers issue riskier and riskier debt, where the boundaries are challenged and where borrowers ask for more, and some lenders jump to provide more. It’s a market fraught with temptation. This is a market that requires discipline. We believe this is an important time to be able to pivot to where the market is affording opportunity. Flexibility is key. We seek out inefficiency and we remain mindful of prudence with respect to our scale.
WSJ: How are you navigating macro risk? Is there one specific factor like the election or interest rates that you’re paying closest attention to?
Russell-Dowe: As investors we are constantly evaluating the basic economic pillars, and as debt investors we are looking closely not only at the fundamental health of the economy, but we are looking at the potential impact of the economy on inflation and on the path of interest rates. While we do not think policy rates have much impact directly on the U.S. economy, they have a material effect on the market’s economic expectations. This idea of market expectation and what is “priced in” is key for us. We are looking at areas where the market has mispriced risk, this is how we find value, even in debt.
We’ve been of the mind that markets have consistently underestimated the economic strength in the U.S., and particularly, the potential spending strength of the consumer. These upside economic risks can have a material impact on inflation as well as on the Federal Reserve’s policy decisions. For the past several years, we have seen differences between our expectations around the path of rates compared to those of the market, so this has been one of the most important factors we are thinking about. Volatility increases when the actual is different from the expected, and with risk asset pricing being relatively rich [like risk premiums being lower], understanding the potential for increased volatility is one reason why we look at the potential divergence of actual interest rates from the market’s expectations. A better-than-expected U.S. economy may mean more inflation, or it may
mean higher than expected policy rates, so interest rates and economic growth have been key economic factors to follow.
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Proskauer Rose announced a 1.84% overall default rate for Q1 2024 for loans in its Private Credit Default Index, which tracks senior-secured and unitranche loans in the U.S. and includes 980 active loans representing roughly $150 billion in original principal amount.
The Q1 default rate is a slight increase from the prior quarter and the second consecutive increase in the overall default rate. In Q3 and Q4 2023, the rates were 1.41% and 1.60%, respectively. However, this quarter’s rate remains lower than the default rate a year ago. In Q1 2023, the default rate was 2.15%.
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NextEra Energy Partners is mulling its options for how to pay bills coming due under an obscure type of financing that has weighed on the company since its stock price tumbled last year. One option is raising capital from private investors, John Ketchum, chief executive of the company and its majority owner, said during an earnings call this week. “Those discussions continue to move forward,” he said.
Brightwood Capital, a private-credit lender to small and midsize businesses, faces a legal challenge over a roughly $253 million continuation-fund deal set up with Banner Ridge Partners involving several Brightwood funds. Banner Ridge, a specialist credit investor, sued Brightwood earlier this month alleging that the fund sponsor had reneged on an agreement last year that called for Banner Ridge to acquire secondhand stakes in several Brightwood private-credit funds for as much as $253.5 million.
Franklin Templeton, long known as a big investor in stocks and bonds, has quietly become a major force in private markets. The 77-year-old asset manager made its name marketing mutual funds for individual investors. Thanks to a recent spate of acquisitions, it now manages more than $260 billion in so-called alternative assets such as private credit.
Consultant and asset manager Mercer has wrapped up fundraising for its seventh fund designed to give less well-resourced investors access to a range of private markets. The firm raised $3.9 billion for Mercer Private Investment Partners VII, which it plans to invest across private equity, private credit, infrastructure, real estate and sustainability-driven investments.
Private-credit specialist Ares Management has begun gathering capital for its first fund to finance specialty healthcare businesses. The fund manager with $418.85 billion in assets at the end of December aims to raise $1.5 billion for Ares Specialty Healthcare Fund, which will primarily lend to businesses focused on pharmaceuticals, biotechnology, medical devices, diagnostics and specialty services, according to public documents.
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Schroders Capital, the specialist private markets division of the Schroders Group, expanded its Private Debt and Credit Alternatives business with two senior appointments. Jason Kezelman joined the firm as head of U.S. PDCA sales within Schroders Client Group. He joins from TPG Angelo Gordon where he was a managing director and strategy specialist in the Client Partnership Group. Loren Sageser has joined the PDCA team as senior product strategist. Sageser was previously a managing director and product specialist at Nuveen.
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Blackstone delivered higher-than-expected first-quarter earnings as the world’s biggest alternative asset manager raked in money from its credit strategies. Much of the money brought in—$17.2 billion—was through its credit strategies, which include private corporate credit and infrastructure and asset-based credit strategies for energy investments. (Barron's)
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Goldman Sachs, like its competitors across banking and private equity, is trying to expand its offerings in the lucrative private markets. The firm recently emphasized its efforts to grow its private-credit assets to $300 billion from $130 billion in the next five years. (Barron's)
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Private credit is now so big that the International Monetary Fund dedicated an entire chapter in its latest Global Financial Stability Report to its “rise and risks”. But JPMorgan argues that even the IMF is underestimating the true size of the industry. (Financial Times)
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Send us your tips, suggestions and feedback. Write to: Isaac Taylor
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