Principal predicts “manageable” default rates for direct lending market
Principal Asset Management has predicted that default rates in the direct lending market will be “manageable” this year, despite fears of a cliff edge for private loans.
The alternative asset manager suggested that annual default rates could approach two to three per cent for the private middle market, while credit losses should remain within the 75-125 bps range.
“In this scenario, the return to investors will be quite compelling, as the typical yield for performing first-lien, floating-rate lower and core middle market direct loans remains over 12 per cent,” said Tim Warrick, head of alternative credit at Principal Asset Management.
Warrick also predicted that the direct lending sector will see an increased focus on economically resilient business models, with fund managers seeking out more conservative leverage profiles and more compelling valuations.
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He added that he expects to see more lender-friendly transaction terms, with reasonable original issue discounts, improved call protections, tighter financial covenants, and more conservative EBITDA adjustments.
“Easing credit conditions may contribute to the economy’s resiliency and borrower performance through the cycle,” said Warrick.
“As the market may be getting ahead of itself in anticipating a soft landing, lenders must remain focused on underwriting through a potentially challenging cyclical downturn.
“Continued economic uncertainty and higher rates contribute to several supportive trends for middle market direct lending and an opportunity to enhance risk-adjusted returns relative to historic loan vintages.”
In its third quarter Fixed Income Perspectives Outlook, Principal noted that deal activity in the private equity and private credit markets has picked up in 2024. However, loan volumes in direct lending have reduced due to tightening credit conditions, an uncertain economic environment, and slowing M&A activity in 2023.
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“Despite this, middle market direct lending has continued to fill the void left by commercial banks and the continued decline in syndicated loan market issuance,” said a Principal spokesperson.
“While volume is up more significantly in the syndicated loan market compared to last year, much of this is refinancing and repricing of existing loans.
“Though new loan volume origination for private middle market direct lending started the year much like 2023, the volume is beginning to increase to more typical levels.”
Principal observed that the lower and core middle markets are showing strong value for investors.
However, the firm expects to see investment grade private placements slow into the “typically sluggish August issuance schedule” before picking up towards the end of the year.
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