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Private Credit 

David Brooke

This article is part of our new service, 9fin Private Credit, which will soon require a separate subscription to view. For more info on this product and the accompanying database, contact subscriptions@9fin.com

Perhaps it’s now time to *gasp* think about the election. Primaries kick off next month and if you’re looking 12 months ahead (as any good investor should) there will (hopefully) be a President elected.

Investors abhor any kind of uncertainty, but the four-year cycle is built in and the endless amount of media coverage should help to illuminate what policies, taxes or otherwise, are likely to be implemented.

Nevertheless, things are good for now for private credit — and are seemingly only getting better compared with private equity. 

Even if M&A activity picks up next year, it’s fair to ask how long that revival would last because another expected dramatic election would probably interrupt deal flow in the second half of the year. And if deal flow is depressed, private credit is likely to continue its triumph over its private equity counterpart.

For as a recent report from State Street shows, the understanding that private equity delivers higher returns, has been upended. Private credit outperformed the overall private equity asset class in Q3 with a total return of 2.61% compared to 2.29%. 

Private equity and private credit have forged a very close relationship since the latter’s coming of age following the global financial crisis. This relationship is, of course, so close that many credit shops sit under a private equity parent, and in some instances help finance those firms’ buyouts. But if private credit is to continue much of its success, it needs its big brother private equity to keep the deal making going.

All of this means key questions for LPs. Many of those first allocating to private credit when it was in its infant years did so from alternatives buckets, where private equity, real estate and infrastructure investments sit. Private credit arrived as a lower yielding, but less risky option and deployment could be made to an asset class with a fixed income.

Others allocated from their fixed income buckets, pulling from less-risky credit investments made where yields were at historic lows during the ZIRP era. That shift unlocked a wave of capital into the private credit market. Does private credit become a replacement for private equity allocations?

So a sluggish buyout pipeline means private credit may continue its triumph over its private equity counterpart, but to what end?

Readers with a long memory may remember a little quip about the midwestern HVACs in the first Unicrunch back in May. It’s a popular industry, but we got the region wrong — two companies 9fin broke news about yesterday (Thursday) are featured in the southwest (although a quick Google search is there has been a flurry of HVAC deals throughout the country in the last couple of years).

Oklahoma-headquartered AXH air-coolers secured $100m in debt financing from Bain Capital Credit to finance an acquisition by Windjammer Capital Investors. This transaction has landed at 675bps with a sub-3x leverage, a somewhat handsome deal for Bain, especially in light of a flurry deals pricing below 600bps in recent weeks (BMI and and Harrington Process Solutions).

Of course, at $100m it’s a different ballpark from the $700m for Harrington and $600m for BMI. But Bain, as the firm says on its website, likes companies in the $10m to $150m EBITDA range. One can guess that AXH-air coolers is at the lower end of the EBITDA range — where the covenants still exist.

Another HVAC company in the pipeline is Texas-headquartered KwiKool. A maker of portable air conditioners, the company is on the block, marketed with a mid-teens EBITDA, portending a possible buyout financing size similar to AXH. Direct lenders are on it, 9fin reports. 

Say smaller companies are a riskier prospect for direct lenders and you’ll get a strong argument that this is not the case from people who specialize in financing them. As Art Penn on PennantPark’s BDC earnings call last month said:

That [smaller companies are riskier than bigger companies] is a perception and may make some intuitive sense, but the reality is different. 

He went on to say that default levels (citing S&P data) and leverage levels are lower, spreads and OIDs are higher, and covenants are tighter in smaller deals than in the upper middle market. 

For KKR, publishing a white paper, there is the opposite narrative. 

Smaller companies have a more difficult time navigating difficult market conditions and may have fewer places to turn to borrow or refinance than larger companies.

Who is right is not totally clear. No matter if you’re targeting companies at the upper or lower end of the market, you have to get the underwriting and due diligence right.

The debate is forever ongoing: stronger protections for lenders versus liquidity questions for the borrower in times of stress. Indeed, you cannot so easily resolve this argument, but one issue that’s comparable in both segments is the competitiveness of the market. 

At the upper end there are some familiar names, while at the lower end there is a larger number of players without, quite frankly, the same high level of branding. Competition thins out the lower you go and many of those targeting the lower middle market operate more quietly.

Yet the debate may be academic as more money is set to pour in to the market over the next few years. The pie will be big enough for both upper and lower middle market strategies as they attract more capital from institutional investors.

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