Executive Summary
- Contrary to earlier concerns, a recession has not materialized yet thanks to the unexpected resilience displayed by global economies. This positive development has bolstered market confidence in the prospect of a soft landing, and financial markets rebounded in 1H23 as a result. However, this increased confidence might have obscured the potential challenges that could adversely affect the economy.
- Transaction volumes fell significantly during 1H23. Subdued M&A activity is a big reason why. Under these circumstances, alternative sourcing channels such as secondaries offer attractive opportunities to deploy capital. 1H23 demonstrated a more lender-friendly market with new deals sourced with lower leverage.
- Middle-market companies also showed surprising resilience in the face of the current macroeconomic challenges, managing to increase EBITDA over the two previous quarters. However, earnings growth is expected to soften in the coming quarters as the impact of higher interest rates flows through the economy. Some industries might be affected more than others. Higher base rates may also put temporary pressures on interest rate coverage ratios. But, firms have multiple tools to address this issue.
- Historically, private debt has demonstrated resilience, even during economic downturns, thus offering relatively attractive returns to investors. The current market environment may also produce an interesting vintage enabling the deployment of capital on favorable terms.
Public markets: increased risk appetite
1H23 displayed a risk-on environment…
After the events of 2022, which prompted investors to retreat from the higher-risk segments of the market (e.g., public equities and sub-investment-grade credit), 1H23 witnessed a notable reversal of this trend. The investment environment shifted toward a risk-on sentiment. This shift resulted in double-digit returns within the public equity markets of the United States and Europe.
…which led to a “priced for perfection” situation in public markets
Additionally, there was a remarkable rebound in the public sub-investment grade debt market from the previous year. Returns in 1H23 ranged from 6% to 8%. Taking a closer look at the secondary spreads within the public debt market, current spreads appear to be close to their historical averages. When compared with the levels observed during the Great Financial Crisis or the pandemic, current spreads seem to imply that the market does not anticipate any macroeconomic challenges in either of these regions.
However, considering the uncertain macroeconomic outlook as we approach 2024, alongside the expectation that rates will remain higher for longer, public debt valuations may very well be inflated. These valuations may not account for the risks that investors could encounter in the near future. Against central banks’ guidance, markets are pricing in rate cuts as soon as 2Q24 according to forward curves. The anticipated rate cuts are contributing to the current market enthusiasm, but the “higher for longer” stance may yet lead to a hard landing and a correction in valuations.
We expect private debt to remain resilient and offer attractive relative value
Rich valuations in public credit markets underscore the attractive relative value that private debt can offer. Direct lending has, on several occasions, shown its resilience through limited drawdowns and valuation stability when compared with its counterparts in the public market. These distinctive features of private debt could emerge as pivotal factors to safeguard returns, particularly if the economy takes a turn for the worse. Because of this track record of stability, we expect private debt to perform as it has in the past, any macroeconomic headwinds notwithstanding. Furthermore, owing to a lender-friendly market that allows lenders to be picky, the current vintage may provide ample opportunity to deploy capital on favorable terms.
A potential turn in the credit cycle could also create more opportunities in the secondary space. Activity picked up, and we expect it to remain high in the upcoming quarters. If it does, investors could have even more possibilities to deploy capital with attractive discounts at a time when primary volumes are subdued. Moreover, other private debt strategies such as opportunistic lending or specialty finance stand to benefit from the situation. Companies with sound business models but stretched balance sheets could prove attractive investment opportunities with the potential for high returns.
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