1. Where do you see the greatest opportunity in European leveraged finance right now?

We believe the next few years are going to be a very good time to be a lender and the nuances of whether you sit on the private or public side of the fence are becoming less important.

There’s a lot of private equity dry powder right now and I expect GPs are feeling a healthy pressure to put that to work. Most private equity backed transactions are debt financed, so we expect to see a positive change in deal activity. Combine that with the refinancing wall and there is going to be a lot to do if you are a lender with capital over the next few years.

Enhanced transaction activity is going to be positive for leveraged finance professionals wherever you sit in the industry value chain: a distribution bank, a commercial bank, a high yield bond fund, or on the private credit side.

Additionally, in the current environment of elevated interest rates, total returns remain good versus historic norms, meaning asset allocators are generally still favourably disposed. While this high-returning landscape may not last indefinitely, the overall system is well underpinned.

2. What stands out as the biggest threat to financial stability in leveraged finance markets at the moment?

I don’t see much that could lead to an existential industry risk. The pain points are probably in existing portfolios and I suspect we have not yet seen the full impact.

First, there are fundamentally strong companies that have too much debt on their balance sheets because of the historical low interest rate environment. I think none of us ever anticipated inflation and interest rates reaching their current high. However, this should be manageable, and I would classify it as stress rather than distress.

On the other hand, there are inferior companies that managed to raise debt historically because it was a commodity; many people operated under the assumption that favourable conditions would last indefinitely. Unless we see a notable positive change in the macro rate environment, some of those companies will likely fall into distress. While I don’t expect that to be a significant threat for financial stability as the incidence will likely be low, it could have an impact on investor perceptions and their propensity to commit more capital to private credit.

3. Rating agencies expect rising default rates to test private credit funds this year — what will be the wider market fallout?

I expect to see an increase in defaults with a small ‘d’. Many potential issues can be largely mitigated through structural adjustments that decrease near-term cash flow stresses. Things like agreeing to payment-in-kind (PIK) interest, extending maturities, or relaxing covenants.

A common point of confusion is the absence of financial covenants in the public markets. Focusing on lenders resetting covenants to signal systemic risk in private credit overlooks the fact that covenants are beneficial and are not present in most markets. A covenant reset does not imply that private credit is inferior to public credit. Often it is a rational reaction to a borrower’s question.

In situations where a company can’t pay its interest and its existing debt is maturing, if lenders aren’t prepared to extend then that is where we will see defaults. We expect defaults will be skewed towards two types of transactions — smaller companies and specific sectors.

Firstly, with smaller companies, I see a number of businesses out there that were created by very charismatic and persuasive entrepreneurs and supported by readily available cheap capital. However, without continued access to cheap capital, these businesses may prove unsustainable.

In certain sectors, we’ve seen significant increases in input prices for labour and other goods as companies have re-engineered their supply chains, often due to geopolitical concerns. If these companies cannot pass on costs or face a fall in demand, this could lead to significant overleveraging and, without the injection of new capital to repay debt, defaults.

4. As competition ramps up with syndicated markets, what is direct lending’s unique selling point in 2024?

There are three key areas where direct lenders provide a service proposition. The first is certainty. A lot of what we do is provide financing to private equity firms or private individuals looking to buy a company. If they sign an agreement with a direct lender, they know precisely how much debt they can borrow and what the cost of that debt will be. If their next best option is going to investment banks that will underwrite a syndicated deal, the borrower won’t know what the cost of financing is until the banks are finished selling the debt. In many instances, borrowers do not want to stomach that risk and therefore place a premium on the certainty of direct lending.

The second service, that we expect to become more relevant given the macro environment, is providing a bespoke financing package tailored to a borrower’s needs. Over the last 20 years, deflation and falling interest rates have meant the private equity playbook often consisted of picking a great business, financing it cheaply, and waiting for the multiple to expand before selling it. I think that playbook has changed so that now, to generate those excess returns, a private equity investor needs to think more traditionally and drive value through operational change and strategic M&A. Direct lending is more sympathetic towards this approach than the syndicated markets, where the investment banks will structure the financing package based on what their experience says the market will buy.

The third service is depth of capital pools. Direct lending has scaled massively compared to where it was five years ago. There simply wasn’t sufficient AUM for the industry to be relevant in that many transactions. That has now changed and the universe of potential opportunity for direct lenders has expanded.

The benefit of being at KKR, with both its public and private credit businesses, is that I get to see both sides of the equation. I suspect direct lending will always be the little sibling to the syndicated markets, but I think we’ll see direct lending taking more prominence moving forward.

5. Some direct lenders have started to reprice loans to deter sponsors from seeking cheaper refinancings in the syndicated markets — is this a viable long-term strategy?

No. An element of what we are seeing now is a function of the market being too good 12 months ago, and in many instances, things are normalising to where those loans should have priced initially. There is also some technical pressure in that a lot of capital has been raised for direct lending and we have yet to see the buyout market bounce back in earnest. It’s certainly better, but more capital is available than there are transactions looking for capital.

In my opinion, those two factors are driving this repricing wave. If it became the new norm and lenders had to reprice every 12 months, that’s certainly not sustainable. I think about it as a pricing pendulum — we were at one extreme and have currently swung back a bit further than necessary, but if buyouts pick up, we will settle at a new norm. Our best guess is a margin of around 550bps, maybe a little wider for smaller businesses with complexity and a little tighter for larger, simple businesses.

6. Fundraising and deal execution has become challenging for all but the most established private credit firms in recent years. How are struggling firms going to get out of this rut, if at all?

We are starting to see a bifurcation in the industry. On the one hand, you have a small number of scaled players with broad and deep private credit platforms across origination, underwriting, and investing. These platforms offer investors multiple solutions across different funds and geographies.

On the other end, we are seeing specialised smaller players catering to niche markets, such as direct lending for Nordic healthcare companies or venture lending for continental European technology businesses. While these may sometimes not be hugely scalable, their specialised focus and on-the-ground presence offer unique benefits for portfolio diversification, which will likely be appealing to allocators.

For firms caught in the middle ground, I think they will need to demonstrate exceptional performance, as it may become more challenging to position themselves with asset allocators moving forward. Having great people and a top quartile track record should certainly help but, by definition, not everyone can be the in the top quartile.

7. What shift does the market need most right now to bring back M&A activity in full force?

A narrowing of valuation expectations between buyers and sellers.

The situation is better than it was. 18 months ago, there was no consensus on where rates would peak and, consequently, what the stable cost of capital would be. This combined with a lot of privately held assets being worth less than they cost led to a dramatic slowdown in activity.

Wind forward to today and the good news is rates seems to have peaked, and commentators expect us to enter a loosening environment — likely sooner in Europe than the US. The capital is there to invest, it is just a question of whether buyers can make the math work.

My strong view is that M&A activity in the next 12 months will be greater than the preceding 12, but it’s hard to predict when we will see it back in full force. Ultimately it will come down to whether enough people need to make deals and whether they can find things they want to buy at a price that works for them.

8. Having worked in credit during the Global Financial Crisis, what’s one lesson from 2008 you think rings particularly true today?

Looking back, the thing I learnt as a lender was that you need to set out your stall one of two ways — you either lend to great businesses that are durable and have a reason to exist, or you invest in highly structured credits where the documentation is unequivocally lender-friendly. If you are disciplined and focus on either, you will do well, but I think a lot of people get caught somewhere in the middle, either through a lack of experience or a lack of bargaining power. Businesses that aren’t great require a lot of thought around structure and documentation, and I think people forget that when times are benign.

That is why at KKR we have this slavish devotion to quality of business. We start every discussion on potential opportunities asking ourselves whether it is a good business to lend to. There are good businesses that are all about equity, but is it a good credit business? That was a narrative that, two or three years ago, many people did not want to listen to. I think now people are starting to recalibrate and realise the importance of that as the macro environment has become more challenging.

9. How does a partner at a global credit firm unwind at the weekends?

My midlife crisis has been windsurfing, so that’s what I spend my free time doing in West Sussex when I get the chance. The beauty is you can’t take your phone, obviously, and when the wind is really blowing you have to focus on self-preservation, so it’s a wonderful way of clearing the mind. When I retire, I want to take a few months to try and windsurf along the Mediterranean coast, from Spain to Italy.

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