The Federal Reserve recently signaled that its rate hiking cycle has peaked. This potential pivot will have far-reaching consequences for the booming private credit industry this year.
In December, policymakers at the Federal Open Market Committee announced that they had voted unanimously to keep their benchmark overnight borrowing rate steady between 5.25 percent to 5.5 percent.
Members of the committee are also forecasting rate cuts in 2024, according to the dot plot published by the Fed. The bond market reacted instantly, pulling the yield on 10-year U.S. treasuries below 4 percent.
However, the impact on private credit, particularly in the middle market, is more complicated and nuanced.
“The yield on private credit floating rate loans move with underlying base rates,” says David Ross, managing director and head of private credit at Northleaf Capital Partners. “But through most cycles, there has been a stabilizing effect where a decline in base rates is partially offset by an increase in credit spreads and vice versa.”
Unitranche spreads hit 620 basis points in September 2023, according to a recent credit report from investment bank Raymond James. However, this headline figure doesn’t fully capture how spreads vary in different segments of the market. Ross explains that the deal terms and pricing in different segments of the market, from upper-end to lower-middle, could be very different.
Bain Capital Credit is a key player in that core middle market lending segment with a primary focus on investing in companies with $25 million to $75 million in Ebitda.
Michael Ewald, global head of private credit at Bain Capital, says there’s more dealmaking activity on the horizon. “If the Fed thinks they’ve achieved what they need to achieve, and now rates can come down a little bit, I think the biggest impact of that would be a loosening of the logjam of deals,” he says. “There is a lot of pent-up demand for deals that private equity sponsors have been waiting to sell.”
He compares the situation to the housing market, where mortgage costs have skyrocketed, but property owners have been unwilling to sell at lower prices. Home sales have plummeted and a similar trend has played out in the private credit market. “Sponsors have been stubborn to realize that new reality and to drop their asking price. What they’ve done instead is held onto companies longer,” he says.
But with more clarity on interest rate trajectory in 2024, this scenario is starting to shift.
“As we have reached comfort with rates in the fourth quarter, you’ve actually seen more deal activity as sponsors have become more comfortable in their modeling,” Ewald says.
In other words, buyers can now justify meeting seller expectations because lower rates will make more deals pencil out. Ewald says if rate cuts materialize in 2024 that should “accelerate dealmaking.”
“I do think it’s a hot segment of the market that gets a lot of attention,” he says. “However, it has become more popular as an option for larger cap companies because they don’t really have any alternative sources of capital. As a result, private credit has broadly displaced the syndicated market.”
Ross has a similar perspective. “Deal pipeline is looking very strong going into 2024. In particular, private credit managers with mature portfolios of diversified, performing borrowers will see attractive refinancing, add-on and upsize opportunities,” he says.
Contact David Ross at [email protected]
