Private credit in the spotlight
Sixth Street Specialty Lending is a Business Development Company (BDC) providing flexible financing solutions to middle market companies principally located in the US. Founded by $65 billion global investment firm Sixth Street in 2011, Sixth Street Specialty Lending partners with companies with complex business models and limited access to capital. As of December 2022 it had approximately $2.8 billion invested across 78 companies and 43 structured credit investments.[1]
Private lending offers investors attractive risk-return profiles as these loans tend to be senior in the capital structure, secured by company assets and protected by strong covenants. The market has grown more than 6-fold since 2008[2], reaching $1.4 trillion in value by the end of 2022.[3] In recent years the private credit market has been making inroads into traditional sourcing of investment. For example, eroding syndicated leveraged loan market share—deals of less than $250 declining to just 9% in 2020.[4] In contrast, mid-market borrowers have begun flocking to the private credit market in order to secure financing.
Adapting to market volatility
Despite the private credit market’s strong position, macroeconomic instability has meant that private credit companies need to adapt to a changed environment; market pressures such as inflation and supply chain disruption have cut into the margins of many middle market companies and impacted their cash flows—raising the risk of defaults. This has led to a shift in focus for Sixth Street Specialty Lending.
“Our target markets have changed over the last couple years; we’ve built capabilities and origination and sourcing to finance much larger businesses given the change in the capital markets,” says Joshua Easterly, CEO and Chairman, Sixth Street Specialty Lending. “I think that’s a theme for all direct lenders and private credit providers,” he adds.
“There has been disruption in the capital markets, the Broadly Syndicated Loan market and the High Yield market have not been functioning and pressure on bank balance sheets has increased. Private credit is really picking up market share.
“In the quarter to date, approximately 75% to 100% market share has gone to companies that are looking for capital, either through LBOs or refinance or being done in the private credit markets.”
"Our target markets have changed over the last couple years; we’ve built capabilities and origination and sourcing to finance much larger businesses."
Joshua Easterly, CEO and Chairman, Sixth Street Specialty Lending
A focus on resilience
The US Federal Reserve began increasing interest rates in March 2022, in its bid to curb inflation. This pushed up the cost of debt and created instability in the wider credit market. Despite their strong position, private lenders are not immune to market pressures as inflation and supply chain disruption have cut into the margins of many middle market companies, impacting their cash flows and raising the risk of defaults.
“In a higher base rate environment, it's going to put a lot of pressure on credit and capital structure,” Easterly explains. “So underwriting, which has always been the core of our business, is going to have a big focus this year, which is about financing good companies with good balance sheets that are built for this new economic environment.”
“But we’re also thinking about new sectors, new industries that need capital in this environment and in some ways, focusing on out-of-favor sectors and exercising the muscle needed to get up to speed on those sectors.”
"Underwriting is going to have a big focus this year, which is about financing good companies with good balance sheets that are built for this new economic environment."
Joshua Easterly, CEO and Chairman, Sixth Street Specialty Lending
M&A: Culture is the key to consolidation
As private credit lenders pivot to financing larger companies, they will need to secure additional capital, which may well lead to increased M&A activity in the space. But consolidation is not without its challenges, says Easterly. “Consolidation has historically been very hard given the governance structure of externally managed BDCs.
So I think boards, management teams and founders who are considering M&A should be really focused on picking their right partner and culture. Culture trumps everything.
“They will need to find the right balance between their client base, the people they need to provide capital to and their investors. And then also lead from the front as it relates to the people in their organization.
I think the winners in the next ten years are going to be those who provide a real value proposition to their capital providers and are able to build culture within their teams.”
"Boards, management teams and founders who are considering M&A should be really focused on picking their right partner and culture. Culture trumps everything."
Joshua Easterly, CEO and Chairman, Sixth Street Specialty Lending
Bright future for discerning investors
The private credit market showed resilience in the face of the 2008 financial crisis and attracted increased interest from investors during the pandemic; surging to record levels in emerging and developed markets in 2022.[5] The increased popularity of private credit means that investors need to be discerning when selecting issuers. Taking into consideration factors like experience level and performance will be crucial, thinks Easterly.
“I'm generally pretty positive on the future of private credit, though I think the industry's going to have to continue to evolve. Investors are going to have to not focus on the issuer, but on their actual returns and capital, and the value proposition they're providing their investors.
“Investors in the space right now should be looking at manager skill level and ability to manage credit losses as well as their historical experience. I think finding that right balance will provide a very bright future for private credit.”
This content is based on commentary and analysis from RBC Capital Markets' Global Financial Institutions Conference hosted in New York, NY on March 7-8 2023. For more information about the conference, please contact your RBC representative.
[1] https://sixthstreetspecialtylending.gcs-web.com/
[2] https://www.gsam.com/content/gsam/us/en/advisors/market-insights/gsam-insights/2022/understanding-private-credit.html
[3] https://www.bloomberg.com/news/articles/2023-01-13/what-is-private-credit-industry-poses-regulatory-risks
[4] https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/private-credit-eroding-syndicated-leveraged-loan-market-share-lcd-data-suggests-62952088
[5] https://www.reuters.com/business/private-credit-investments-surged-89-2022-report-2023-02-22/