9fin: What are your expectations for the new year?

The prognosis for 2022 seems pretty positive — I’d say that default rates will remain muted, we are coming off very low default rates in 2021 and we see that very much continuing into 2022 and 2023. 

2021’s default volume is on track to be the lightest since 2007, with loan default rates running well under 1% per annum, well under the assumptions for the double-B and single-B ratings categories.

We also look at loans trading at 80 or below as a leading indicator of defaults, and that’s also running very low, with less than 1.5% of outstanding loans trading at this level — suggesting low implied 12m default rates.

The earnings we’re seeing for the third quarter have also been strong, and there’s been a significant increase in the pace of corporate rating upgrades this year, partly as rating agencies downgraded companies very aggressively in the second quarter last year.

We’re coming off a record year for leveraged loan supply and a record year for CLO issuance — global CLO issuance is north of $180bn and total market outstanding has now passed $1trn, levels we’ve never seen before. But a record year is rarely succeeded by another record year, and I don’t expect that level of activity to be sustained. I think we’ll come back to the longer-term trend in 2022.

2021 started with huge pent-up demand from 2020, and I think we’ll end up looking back on [2021] as a complete anomaly with the historically high levels of issuance.

Everyone is talking about underlying inflation, which is running at a 30 year high, with global inflation projected to run at around 3%-3.5% for 2022, and we’re seeing this come through in the companies we invest in. There’s no question any more that it’s not a one-off thing, and we will continue to see this through 2022. 

The trick as a credit manager is to invest in companies and in sectors that can best deal with inflation. Companies with pricing power, companies that are able to pass on increased costs because of their position in their industry, because of their size, because of their relations with customers. That’s partly why we prefer to focus at the large cap end of the spectrum, with Ebitdas in the 100s of millions. 

Industries like pharmaceuticals, healthcare, software, service business, especially government services, and even media and telecoms have been able to deal with the inflationary trend. But we’re trying to stay away from businesses like retail which find it much more difficult to pass costs on. 

In 2022 we also expect some volatility in the US market, because of the switch from Libor to Sofr. We’ve been talking about this switch for a long time, and everyone’s had a long time to get prepared, but I’d still expect some disruption, though we expect this will subside a few months in.

The big uncertainty out of leftfield is Omicron — will there be other Omicrons down the road? Are we going to see more variants and more winter waves of Covid? Omicron is already having an impact with events cancelled and some countries implementing lockdowns, but we don’t know how large yet. 

I feel like the market has also baked in a faster recovery from Covid into current pricing levels, so this could prove potentially very disruptive — it’s the big curveball for the year ahead.

9fin: The sectors you mentioned have been some of the darlings of the levfin market for quite a while — how much of the benefits of that positioning are already in the price?

We’re offering our investors basically two things — a high degree of principal protection, and a yield. So our portfolio focus is principally on solid robust companies with large market shares in industries where there’s high visibility of regularised earnings.

But we’re also seeing a lot of demand for loans, and so pricing has essentially held up. If I look over the very long term, and I’ve been doing this for about 33 years, pricing hasn’t really moved much in loans. Pricing has been around Libor+4% for most of the last 20 years…sometimes it goes to 3.5%, sometimes up to 4.5%, but 400 bps is the average and I don’t really see that changing.

9fin: One trend that’s stuck out to us is that LBO EV multiples keep going up — private equity is paying more for the same companies. Why is that, and does it matter?

It’s really just driven by the supply-demand situation. Our business is largely driven by M&A, and that means essentially by private equity, and given our focus, that means dealing with the top 50 or so firms. These guys are sitting on record amounts of dry powder — estimates vary but most suggest around $2trn, which has to be invested in the next three to four years. They didn’t spend much of it in 2020, because they were looking inwards and firefighting, while they came back hard in 2021 and bought a lot of companies, but we expect this to continue.

As a result, prices for companies have been going up — as they have everywhere. I don’t know of any corner of the public markets where prices haven’t been robust, pricing multiples are at record highs across markets.

But this has meant that the equity cheque is also at record highs, at around 45%-50% of the purchase price on average, higher than at any point while I’ve been in the market. So I sleep soundly at night, knowing these guys have put substantial equity behind me — in effect, the Ebitda of these companies has to drop more than 50% for the senior debt we’re providing to be impacted.

The other thing to bear in mind is that across the 600 or so companies we invest in, Ebitda leverage is still under six times. Leading up to the global financial crisis we were doing senior loans at 7x, 7.5x, so in that sense lenders have been keeping good discipline. Across our portfolio, we’re well below 6x forecasted Ebitda, which is reassuring.

It’s also useful that loans are floating rate instruments — if rates go up, as they’re expected to do twice in the US in 2022, our investors benefit, they’re not locked into the price declines of being in a fixed rate high yield bond.

9fin: I take the point on the leverage, but a lot of people say that, with weak documentation, Ebitda add-backs and so on, many of these 6x companies are really 7.5x companies or higher. With weaker docs, you should also arguably adjust recovery assumptions down as well

That’s an absolutely valid point, but of course we’re trying to look beyond the adjusted Ebitda figures, haircutting those figures, putting probability weighting on elements of the Ebtida number. 

On the documentation point, covenants have been pretty much non-existent for the best part of five or six years, and we never did a deal because it had covenants in — we always start with bottom up analysis to figure out if we want to invest with them.

If we have to rely on covenants, it’s already too late. I don’t see the documentation trend reversing until there’s a market correction down the road. If we see that, then documentation will tighten, some elements of covenants will come back for a short period, but then we’ll be back to what we’re experiencing now.

The crucial thing is to stay on top of the investment, track the company's results, and if you feel like it’s not going to hit the budget or it's trending down, you can be a proactive player in the secondary market.

That’s a really important feature of the market that’s really grown year on year, a big positive if I compare today’s market to five or 10 years ago. You can just sell up if you’re nervous about a company, and there’s a big wide world of fund managers out there with different views, actively trading loans, across a larger universe of outstanding loans. Secondary market liquidity is greater today than it’s ever been.

9fin: What do you expect on the ESG side?

We expect ESG issues to be even more prevalent in 2022 than in 2021, though clearly this is an area where Europe is a long way ahead. The regulatory backdrop is helping to drive this change, with the European Union leading the charge for standardisation across the markets. We’ve seen a huge amount of ESG high yield bonds issued, including 15 bps-25 bps step ups if companies don’t hit targets. I expect investors to be much more focused on managers really taking ESG seriously, and I think the best place to be is ahead of that curve, with very strict ESG criteria in our investment process.

I think ESG ratings are also going to become increasingly important for companies, almost like credit ratings, and we’ll see substantial progress in that direction during 2022.

9fin: Do you have any concerns about the growth of the private credit market? Could the jumbo unitranche deals start to cannibalise supply?

Put simply, I don’t think we’ll see that hurt supply because the overall demand for financing is growing quickly enough for the syndicated loan market and the private credit market to deploy cash at the same time. We do expect private credit to continue growing and doing larger deals but the rate of M&A activity and loan market should ensure that there’s plenty of supply available.