Monthly Commentary

Plain sailing - how credit beat the crisis and can beat inflation too

03.02.2022

CVC Portfolio Manager Pieter Staelens has been featured in LPeC's 2021 Annual Market Review discussing the role of credit in private finance. The full report is available on the LPeC website.

Despite the severe curtailment of economies around the world in 2020, asset markets performed very strongly. The willingness of developed-market central banks to underwrite equity risk as a by-product of doing "whatever it takes" to protect economies from COVID-19 has played a crucial role, freeing investors from the shackles of "risk vs return" and allowing them to focus purely on relative expected returns. In leveraged finance, which is where our fund focuses, this has meant that riskier credits have performed much better than expected, pushing down yields on leveraged loans to levels similar to those that existed at the beginning of 2020.

Private credit certainly proved its mettle in this crisis. Default rates on leveraged loans peaked at around 2.5% last year, far below the 10% level they reached in the global financial crisis. Even this peak was short lived and defaults quickly returned to the 5-year 1.3% average. Not only that, but loans typically have security over good collateral so recovery rates on loans in default were very high – around 75% across the market.

The impact of loan losses on returns, despite the worst recession in two centuries, was therefore only around 0.3% against a typical yield (or interest rate) of around 4%. Very few companies now see their loans trading at distressed valuations (fewer than 1 in 100). Therefore, even as government support is removed we do not expect default rates to rise significantly because economic growth looks encouraging.

Perhaps counter-intuitively, we also see the leveraged loan market as a hedge against inflation. Inflation has risen everywhere, partly as a transitory rebound related to shorter-term supply constraints and the unleashing of pent-up demand, but higher inflation may persist longer than some think. Policymakers clearly intend to run their economies hot for a time – there is little sign of significant fiscal tightening and central banks remain committed to providing support. But central banks will not tolerate an inflation overshoot indefinitely and will raise rates to meet the challenge.

On the other hand, a lot of investors have become used to ignoring interest-rate risk in their portfolio. For those who still want to generate a secure, reliable income from their credit allocations, leveraged loans provide an often-overlooked alternative. As base rates rise, so the interest rates on leveraged loans will rise too and, unlike in the bond markets, capital values should not be affected by this sea-change.

The market for leveraged loans is growing strongly this year, driven by the record boom in mergers and acquisitions (M&A) and from the dramatic uptick in private equity deal flow, especially in markets like the UK where company valuations are still low compared to the US, for example.

From a sector perspective, we are relatively defensively positioned now, with loans to healthcare companies, for example, offering good downside protection. Last year we made the most of opportunities to buy loans to selected hospitality and travel businesses at distressed prices, but if anything, the market is now unrealistically expecting a quick return to normality for these sectors, so opportunities are thin on the ground and we are a lot more selective here.

About CVC Partners Credit Opportunities Ltd

There are two main markets for corporate borrowing, beyond traditional bank lending. There are the bond markets, where companies issue a bond at a fixed interest rate and pay back their loan in full at the end of its term. And there is the leveraged loan market, where an investment bank arranges a loan for a borrower and funds like CVC Credit Opportunities provide the capital.

For the most part, listed companies use the bond markets while privately owned companies tend to rely on leveraged loans. Bonds and leveraged loans are bought and sold regularly on the secondary market – the former via exchanges and the latter in so-called over-the-counter (OTC) deals.

The most important difference is that leveraged loans have a floating rate of interest which rises and falls as market rates move. The price of a leveraged loan therefore tends to remain close to the initial issue value, except when a company is thought to be in trouble. If investors fear for a company’s future, they will demand a discount and the loan will change hands below par, sometimes substantially so.

This is where the real opportunities lie. Our flexible investment strategy also allows us look for companies whose loans are trading at a discount and consider whether that company can work through its problems before the loan is due for repayment. If it can, there is a capital gain to be made as well as an income that comes from the interest payments. For this reason, we spend a lot of time carefully getting to know and understand the companies whose loans we buy. Most of the time, these companies are owned by private equity funds – they provide equity finance and we provide private credit funding.

Our fund manages €700m of such assets, mainly in Europe and the UK with a small portion in the US, but the leveraged loan markets are much bigger than this, with the loan market having more than doubled in value to €360bn in the last five years. This is a large, liquid and growing market that continues to provide opportunities for investors who want a reliable income with a hedge against inflation.

Important disclaimer and terms of use

These written materials are not for release, publication or distribution, directly or indirectly, in or into the United States, Australia, Canada, South Africa or Japan or to "U.S. persons" as defined in Regulation S under the US Securities Act ("US Persons"). The information contained herein does not constitute or form part of any offer or solicitation to purchase or subscribe for securities in the United States, Australia, Canada, South Africa or Japan or any other jurisdiction where to do so might constitute a violation of the relevant laws or regulations of such jurisdiction. The Company has not been and will not be registered under the US Investment Company Act of 1940, as amended (the "Investment Company Act") and, as such, holders of the Company’s securities will not be entitled to the benefits of the Investment Company Act. The securities discussed herein have not been and will not be registered under the US Securities Act of 1933, as amended (the "US Securities Act"), or with any securities regulatory authority of any state or other jurisdiction of the United States and may not be offered or sold in the United States or to, or for the account or benefit of, US Persons absent registration or an exemption from registration under the US Securities Act in a manner that would not require the Company to register under the Investment Company Act. No public offering of securities will be made in the United States. No securities may be offered or sold, directly or indirectly, into the United States or to US Persons absent registration or an exemption from registration under the US Securities Act and in a manner that would not require the Company to register under the Investment Company Act.

In addition, in the United Kingdom, these materials on this website are only being distributed to and are only directed at (i) persons who are outside the United Kingdom or (ii) to investment professionals falling within Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (the "Order") or (iii) high net worth entities, and other persons to whom they may lawfully be communicated, falling within Article 49(2)(a) to (e) of the Order (all such persons in (i), (ii) and (iii) above together being referred to as "relevant persons"). Securities to which the materials relate are only available to, and any invitation, offer or agreement to subscribe, purchase or otherwise acquire such securities will be engaged in only with, relevant persons. Any person who is not a relevant person should not act or rely on the materials or any of their contents.

Any communication on this website is only addressed to and is only directed at persons in any member state of the European Economic Area ("EEA Member State") where any required notification or registration for "marketing" as that term is defined in Article 4(1)(x) of Directive 2011/61/EU on alternative investment fund managers ("AIFMD") has been made and who are both:

  1. "qualified investors" in that Member State within the meaning of Article 2(e) of EU Prospectus Regulation (EU/2017/1129), as amended, including any relevant implementing measure in EEA Member State which has implemented the EU Prospectus Regulation; and
  2. "professional investors" in that EEA Member State within the meaning of Article 4(1)(ag) AIFMD.

A list of EEA Member States in which a notification or registration has been made for marketing to professional investors under AIFMD is available on request.

This website should not be accessed by persons in any EEA Member State who are "retail investors" within the meaning of Article 4(1)(aj) of the AIFMD ("retail investors").

Access to electronic versions of these materials is being made available on the webpage in good faith and for information purposes only. Making press announcements and other documents relating to any offering of securities available in electronic format does not constitute an offer to sell or the solicitation of an offer to buy or subscribe for securities, nor does it constitute a recommendation by any party to sell or buy securities.

By clicking on the "Accept" button, I confirm, represent, warrant and agree that:

I am not a US Person or located in the United States, Australia, Canada, South Africa or Japan or any other jurisdiction where to proceed to view the materials on this webpage would constitute a breach of securities law in that jurisdiction, and I confirm that I am permitted to view electronic versions of these materials; I will not forward, transmit or show the materials contained in this webpage to any US Person or person located in, or a resident of, the United States, Australia, Canada, South Africa or Japan or any other jurisdiction where it would be unlawful to do so; and I have read and understood the disclaimer set out above and will read carefully any additional disclaimers or important notices attaching to or forming part of the materials or information on this website. I understand that this may affect my rights, and I agree to be bound by their terms.

I am not a retail investor located in an EEA Member state.