Private debt in the current macroeconomic environment
Private debt provides financing to private companies unwilling or unable to secure traditional bank funding. In a portfolio, they typically offer higher income and return potential with lower correlation to traditional fixed income markets.

Private loans are less affected by market sentiment. Given that private loans are not traded on exchanges, they are less likely to be influenced by investor sentiment, news flow, and other mark-to-market dynamics. Direct lenders are also long-term focused and typically hold loans to maturity.

In the current difficult macroeconomic environment, managers have become more selective and arenegotiating better spreads, lower leverage, and stronger covenants. Difficult market conditions are providing structural support to the asset class. Direct lenders have been taking advantage of the ample dry powder at hand to match financing needs from underlying portfolio companies. Recently, managers also started to opportunistically replace banks and other leveraged loan players as liquidity providers. Importantly, private loans are senior in the capital structure and terms are privately negotiated to form stronger covenants to protect investors.

We anticipate some credit deterioration, but total returns should remain positive. With economic worries deepening and cost of debt increasing, we anticipate some credit deterioration. Private loan default rates remain close to 1%, but could rise in the next few quarters. We note that private loans are underwritten to be held to maturity and typically contain provisions for stress situations, including scope for additional equity injections and debt-for-equity restructurings. Historical data also shows that in previous down cycles, private loans were able to maintain low default rates and high recoveries. Total returns should remain positive in our base case, but the magnitude of the economic downturn and loan book idiosyncrasies will be key variables in defining outcomes. For investors prepared to look past ongoing volatility, we think the asset class remains an attractive source of differentiated income in an endowment style portfolio.

Tactically, we view distressed and special situation strategies as a good way to enhance returns. Financing stress may provide investment opportunities with sponsors that have the expertise to navigate such situations.

Positive drivers

Dry powder: Elevated dry powder means managers have the capital to take advantage of dislocations and liquidity stress.

Deal activity: Leveraged buyout deal volume is moderating from high levels. Financial sponsors are increasingly favoring non-bank direct lenders that prioritize flexibility and certainty of close. There is no shortage of opportunities for direct lenders to deploy capital.

Pricing environment: Managers are negotiating better spreads, lower leverage, and stronger covenants. The floating rate structure of loans suggest higher returns moving forward.

Negative drivers

Negative economic pressure: A prolonged slowdown in economic activity can pose a risk to the borrowers' ability to pay back loans. In a prolonged recessionary environment, deal flow may also decline severely.

Defaults: Default rates are likely to rise, while interest coverage ratios could weaken.

Main contributors: Karim Cherif and Antoinette Zuidweg

Read the original report Private debt 20 January 2023.

This content is a product of the UBS Chief Investment Office.