Opportunity for private credit as LBO deal flow picks up
Leveraged buyout (LBO) activity in the US has reached its highest level since the second quarter of 2022, which is expected to create opportunities for private credit.
A first-quarter credit insights report from alternative investment manager Oaktree Capital Management attributed the pick-up in activity to the belief that interest rates have likely peaked in this cycle; pressure on fund managers to pay back investors; and the fact that many private equity funds’ investment periods are nearing their expiration dates.
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However, the report noted that LBO debt financing continues to face a significant funding gap.
“Private equity funds continue to hold record-high levels of dry powder,” the report said.
“As a result, the demand for debt financing has risen meaningfully. The amount of debt funding needed to support the current level of private equity dry powder is estimated to be roughly $2.9tn (£2.3tn), assuming a debt-to-equity financing ratio of 1.3x.”
Struggling borrowers
Additionally, Oaktree’s analysis highlighted that default rates in US private credit “remain modest” at around two per cent over the past year, or 1.5 per cent and 3.5 per cent for sponsor-owned and non-sponsor-owned borrowers, respectively.
But the firm warned that this could increase as more borrowers start to feel the negative impact of higher interest rates.
“Many companies have seen their interest coverage ratios decline meaningfully over the last two years,” the report said.
“While the Federal Reserve is expected to cut interest rates in 2024, these cuts – if they occur – likely won’t be large enough to meaningfully reduce the pressure faced by many overleveraged companies. This could ultimately lead to an increase in default rates and the need for rescue financing.”
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Borrowers struggling with higher interest rates and muted earnings growth are increasingly looking to bolster liquidity by issuing payment-in-kind (PIK) structures, Oaktree said.
The asset manager says that it is “sceptical about the long-term efficacy of this strategy, as we believe liquidity concerns won’t truly be resolved for companies with unsustainable capital structures unless the fed funds rate falls to approximately two per cent in the near to medium term, an outcome we don’t consider likely.”
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