November 16, 2023
These conditions have many investors wondering where else they can go. At Blackstone, we believe that these macroeconomic conditions have the potential to create a favorable market for private credit.
November 16, 2023
We recently lost the remarkable Byron Wien at age 90, an icon on Wall Street whose wisdom continues to inspire us, as captured in his Life Lessons. His presence will be deeply missed.
Finding opportunities over the past 18 months has been anything but easy. High inflation had the Fed hiking interest rates at its quickest pace in decades and transitioning from quantitative easing (QE) to quantitative tightening (QT). [ 1 ] Uncertainty about future rate hikes, economic growth, and consumer strength turned the 10-year term premium positive. [ 2 ] Ten-year yields reached new highs amid some of the most volatile swings in its recent history. The traditional 60/40 portfolio provided insufficient diversification, as the stock-bond correlation turned positive in
October 2022. [ 3 ]
These conditions have many investors wondering where else they can go. At Blackstone, we believe that these macroeconomic conditions have the potential to create a favorable market for private credit. And history tells us that private credit can bring meaningful diversification to portfolios, including the 60/40. [ 4 ] To discuss the opportunities in this rising asset class and how to navigate the benefits and challenges of higher-for-longer rates, I welcome, as indicated below, the perspectives of Jonathan Bock, Co-CEO of Blackstone’s Business Development Companies (BDCs) and Global Head of Market Research for Blackstone Credit.
Although the S&P has returned an impressive 19% year-to-date through November 15, seven mega-cap tech stocks (+72%) are largely responsible; the other 493 stocks in the index are up only 7%. [ 5 ] S&P 500 valuations remain elevated, and history shows that subsequent 10-year annualized returns at these levels have historically resulted in lower forward returns (Figure 1).
The last time P/E multiples were at this level, the index provided only a 7% annualized return over the next 10 years. [ 6 ] Higher discount rates mean equity returns will likely trail those of recent prior cycles, and market risk is more likely to be a headwind in the QT era compared to the massive tailwind that was QE.
Figure 1: S&P Valuation and Forward 10-Year CAGR [ 7 ] 
In a lower-return environment, with higher interest rates and volatility, investors will be challenged to add value while managing risk effectively. Simply owning the market won’t get it done anymore. During the QE era, market multiples worked in tandem with earnings growth to produce historic returns. From March 2009 when the S&P 500 traded at 13x earnings to August 2020 when it peaked at 23x, a passive investor in the market earned 16% per annum. [ 8 ] Breaking down the total returns by source from December 2009 to December 2020 shows that 44% of the index’s average total return was from multiple expansion. We take a more muted view for the next cycle as multiple expansion was responsible for only 14% of the average annual total return from 1991 to 2008 when rates were both higher and more volatile. [ 9 ]
In a higher-rate environment, earnings growth will drive returns. We believe the relative strength of balance sheets, earnings predictability and cash flow growth are factors in an investment or asset class that will likely eclipse uncertain prospects of future multiple expansion in importance. Quality factors like these can offset some of the risks inherent in an environment of scarcer returns.
Given that positive stock-bond correlation is stronger during periods of elevated inflation, we believe that active portfolio management that incorporates private alternatives with low correlation to traditional public markets can create a more resilient strategy.
Figure 2: US Stock-Bond Correlation [ 10 ]
Market forces of supply and demand are aligning for private credit. Tighter lending conditions and the aftermath of Silicon Valley Bank’s (SVB) collapse caused traditional lenders to step back. With slower bank and leveraged loan growth, demand for partners in private credit is high. Private credit provided 65% of loans for the leveraged buyout (LBO) market in 2021 and 86% for the market as of year to date 2023. [ 11 ]
The private market offers transaction speed and certainty, allowing lenders to provide liquidity at the most senior portion of the capital structure with favorable covenants for investors. In addition to the tailwind provided by today’s market environment is the increase in diversification that has historically resulted from adding private credit to a 60/40 portfolio. From 2015 to 2023, a portfolio that added a 20% allocation to private credit reduced volatility, increased annualized returns, and added 140 basis points of income. [ 12 ]
Of course, not all private credit is created equal, as Jon discusses below. But because there will be winners and losers, skilled managers have an opportunity to stand out. Those managers experienced in due diligence with sufficient scale to build out funds with higher-quality collateral and low leverage in defensive sectors may be able to provide a better cushion. Others are likely to face pressure and more volatile outcomes in such an untested and uncertain macroenvironment.
by Jonathan Bock, Co-CEO of Blackstone’s Business Development Companies (BDCs) and Global Head of Market Research for Blackstone Credit
Investors are often reminded that “higher-for-longer” interest rates bring the prospect of higher investment yields, but they also place pressure on borrowers. Referencing the Lincoln International Private Market Database (“Lincoln”), [ 13 ] allows investors to compare and contrast this point. Today, the private credit market operates at a current average interest coverage ratio (ICR) of 1.5x, although 17% [ 13 ] of companies operate at an ICR below 1.0x when assuming current base rates. If we assume forward rates of 5.5%, the average ICR of the market is 1.4x, while 20% [ 13 ] of companies have an ICR below 1.0x.
Figure 3: Interest Rate Coverage Ratios at Current and Future Rates [ 13 ]
As pressure on borrowers has the potential to increase, we believe this higher-for-longer rate environment creates meaningful dispersion amongst managers because not all private credit, and not all lending, is the same. In this report we will address how private credit managers can create high-conviction portfolios to mitigate risk in the event of persistent higher rates and a potential slowing economic backdrop.
When economic environments are uncertain or choppy, sitting up in the capital stack can be beneficial for investors. When investments underperform, the most senior capital sees materially higher recoveries than capital lower in the stack. This is evident in the liquid credit markets where first lien loans exhibited a 64% recovery rate vs. 24% for second-lien loans and 35% for unsecured HY bonds.
Figure 4: Leveraged Loan and High-Yield Bond Long Term Average Recovery Rates [ 14 ]
There is a homeowner analogy to make here. If you buy a house, the lender provides you money through a mortgage, and you provide the cash for the equity. In the private credit context, managers are like the lender. Private equity sponsors, the owners of the business, are like the homeowner, as they put in the cash equity. If the borrower were to hit a bump in the road, there’s a large built-in shock absorber. Conversely, if you sell your home, you must repay the mortgage before you get your equity out. That is what being senior secured means. Senior loans get repaid before equity owners get their money, which can provide a mitigant to loss in an uncertain economic environment.
Higher rates will pressure borrowers and highlight, now more than ever, that not all private credit will perform the same – sector selection matters. We can see this dynamic in aggregate data from Lincoln, where private credit borrowers in more cyclical sectors are now experiencing default rates of 8% and year-over-year (YoY) cash flow growth of 2%. At the other end of the spectrum are those private credit borrowers in less cyclical sectors, which feature default rates of 3% and cash flow growth of 5% YoY.
Figure 5: Default Rates and Operating Profit Growth for Less Cyclical vs. More Cyclical Sectors [ 15 ]
Importantly, certain managers may choose to focus on lower default sectors, with particular emphasis on stable revenue and low capital expenditure such as software, professional services, and healthcare.
Larger companies are often more resilient in the face of economic headwinds than their smaller counterparts, and historically they have lower default rates. [ 16 ] Empirical data on the private credit market shows that larger companies with $100 million in EBITDA and higher have grown LTM EBITDA at a 7x+ [ 13 ] greater rate and defaulted at a 5x+ [ 16 ] lower rate than their smaller counterparts measured at $50 million in EBITDA or less.
Figure 6:
Private Credit Market
LTM EBITDA Growth [ 13 ]
Private Credit Market
Average Quarterly Covenant Default Rate [ 16 ]
To us, the reasoning for this outperformance is relatively intuitive. Larger companies have greater human capital and financial resources with which to navigate changing economic conditions. A review of those companies in the private credit market provides further evidence to this point.
Today, nearly 20% of the private credit market has an ICR below 1.0x at 5.5% forward base rates, which implies that nearly 20% of the private credit market does not have sufficient cash flow to cover their debt. Of that 20%, over 70% [ 13 ] are companies with $50 million in EBITDA or less. The pressure of higher rates does build, and we believe it will be felt first and most acutely by smaller businesses.
Figure 7: Average Quarterly Covenant Default Rate [ 13 ]
A low leverage profile is a source of meaningful strength in today’s environment. First, a low fund leverage profile increases fund liquidity and/or capital available for investment. A low leverage profile also lowers fund risk in the event asset values fall or losses increase. Private credit funds tend to be levered ~1.0x or not at all, substantially lower than average leverage found in regional banks, currently levered at 9.7x.
Figure 8: Average Financial Leverage [ 17 ]
Ratio of Gross Debt and Deposits to Shareholders’ Equity
Overall, pressure in a higher-for-longer rate environment is building. Investment success for private credit in this environment is likely to be determined by how well a manager is prepared.
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