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TCW is a leading global asset management firm with over 50 years of investment experience and a broad range of products across fixed income, equities, emerging markets, and alternative investments. In each episode of TCW Investment Perspectives, professionals from the firm share their insights on global trends and events impacting markets and the investment landscape.
The markets have been very active in the fourth quarter, and
this was especially true following the presidential election.
The question is, what does this mean for
investors in middle market direct lending?
And how do private credit managers navigate
the challenges and identify new opportunities?
Welcome to the TCW Investment Perspective Podcast.
I'm Will Lloyd, Managing Director and Product
Specialist for TCW's Private Credit Group.
Today, I'm joined by Rick Miller, the Founder and Chief
Investment Officer of TCW's Private Credit Group.
Rick has been managing private credit portfolios for almost 25 years.
Rick, thanks for being here.
Let's dive right in.
One of the biggest questions on everyone's mind is, what
will the proposed tariffs mean for middle market borrowers?
Rick, what's your take on this?
Well, certainly tariffs are not a new subject.
You know that in the prior Trump administration, tariffs were
implemented and caused beginning of the supply chain disruption
that then was certainly exaggerated with the pandemic.
So one, it's not new.
Two, I think folks need to keep in mind that by human nature, we are adaptive.
We figure out alternatives.
We can substitute.
We can find a different path.
I think it's certainly disruptive, and it has inflationary cost pressure
associated with it, because you're moving from what had been this long-term
trend of globalization and finding the lowest cost manufacturing or
provider of products in the world, and you're moving to something else.
But I think by and large, we will adjust.
From a credit perspective, I think managers and investors need to be wary,
need to be aware, and need to be identifying alternative sources for
product sourcing, manufacturing, and alternatives to provide
customers what they need without any significant disruption.
So I think it's been talked about probably more than it's deserved, but
certainly something that as we underwrite credit, we need to be mindful of.
Thanks, Rick.
Looking out to next year, we're continually
hearing about the return of the M&A market.
Do you expect M&A activity to see a robust recovery in 2025?
But the short answer to your question, Will,
is yes, we do think M&A will come back.
But I think it's a little bit of we've got a lot of
information now available to us that maybe we didn't before.
Number one, there's a tremendous amount of dry
powder in both private equity and private credit.
That money will get spent.
Two, the election's over.
So there's a level of uncertainty that has been removed from
the market, and players in the marketplace loathe uncertainty.
So there's a little less.
The expectation for this current administration
is lower taxes, maybe a break on regulation.
So certainly the fuel is there between all the combination
of factors I just mentioned for M&A to do better.
I think maybe the bigger question will be at what
enterprise value multiple will M&A take place.
We certainly are coming off of a 15, 16 year period of extremely
low interest rates, never ending rising enterprise value multiples.
And with rates higher than certainly they were for that period of time and
trying to figure out where they're going to settle out here over time.
And I think there could be some interesting opportunities
for investors, both on the equity and credit side, as
that new enterprise value paradigm is established.
You know, you mentioned high interest rates.
Interest rates have been high for quite a while.
And given that high level of interest rates, wouldn't you expect
defaults to have been higher by now, especially given that
a lot of those loans were made when rates were at zero?
Well, I think I take a little issue with your question.
I think rates are probably more normal today than they
certainly have been over the last 15 or 16 years.
They are definitely higher, but probably at a more normal level.
And now if you look out at the forward curve, you certainly, the
expectation is that they will continue to moderate and decline.
In terms of the expectation for defaults, I think you need to
remember that in the private credit or maybe private asset world,
the ability to defer, delay, hide our sins, if you will, is capable.
You see it in delays in valuation, certainly relative to public
markets, the daily mark to market versus the quarterly valuation
of third tier assets is always an interesting discussion to have.
Specifically in private credit, I think the use of defaults
as the canary in the coal mine has probably been lost a bit.
I think it's certainly still applicable in the public market domain,
but in private markets, the ability to amend documents, to get
ahead of any kind of reported default is just a lot easier.
If you can look out several months, several quarters, you
can anticipate a potential default and amend the document.
In fact, if you look at over the last 12 to 18 months, according to Lincoln
International, the investment bank and valuation firm out of Chicago, we
had three to four times the normal number of amendments in the marketplace.
Those are all potential defaults that now don't get reported.
And in those defaults, the changes that were made to these loan
documents include maturity extensions, the addition of pick interest.
Sometimes equity cash was infused by the owners.
All of this of extending and delaying any kind of real reckoning in many
cases of dealing with a capital structure that may no longer be viable
or a business that has operational challenges that need to be addressed.
And so I think by and large, thinking that rates would
go up and therefore we would see a bunch of defaults
is an understandable expectation for folks to have.
Because if you had balance sheets, debt levels created under
the assumption that rates would stay low forever, they didn't.
And now you have the challenge of dealing with not only these big debt levels,
but now a much higher interest rate, debt service obligations are much higher,
and there's a real challenge of companies to meet that liquidity obligation.
So I'm not surprised given the ability of
private credit lenders to amend their document.
We really view the loan document and as a result, any kind of default that
comes out of that really as tools to protect our investors' principal capital.
They're actionable triggers that allow us to get back in the room and make
sure that our interests are aligned and that our capital is being managed
in a way that we've, one, originally underwrote, and two, we're
in agreement with in terms of maintaining our principal basis.
Does the growth in COV-LITE lending contribute to that,
or do you think it has an impact on recovery values?
You're right, it has.
Thanks for bringing it up.
It's something that I failed to mention here, that the sheer volume of COV-LITE
that's entered into the middle market, it's probably half the market if you look
at the numbers, also delays any kind of real actionable trigger for lenders.
We still view the absence of covenants or covenant-wide or covenant-loose as a
mistake that lenders are making, that it's one of the primary protections that
you have as a bank lender, and our market is, for the most part, giving
it back, giving it away, and giving that optionality to the owners.
We don't think that's a prudent way to lend, and you need those protections.
Certainly, the proliferation of COV-LITE has led to a decline in reported
defaults, and oddly enough, well, I think it also will ultimately lead to our
expectation that recovery rates will be lower in the middle market, because
absent the default, what you're really waiting for
as a lender is the company to run out of money.
If you think about that scenario, that the value of the enterprise has
declined further, you're not being triggered early in a situation,
the value has declined, and your liquidity has now been exhausted.
Not only are you, as a lender, getting to the table a little bit later, you're
getting to the table and having to infuse liquidity to keep the business viable.
I think just the math of that would tell you that you're
going to have a more difficult time maximizing your recovery.
There's a lot of pain that comes with that COV-LITE move
that I think we still haven't seen in the marketplace.
One of the things we've seen in the market has been these
joint ventures between banks and private credit managers.
I'm kind of interested, does that say anything
specific about the state of the middle market?
Certainly, I think it's a continuation of the story
of why the private credit asset class has come about.
This was, as many have said, a very intended consequence
of the regulatory bodies overseeing the banking industry.
In the 90s, you really saw the disintermediation of the larger money center
banks, came for the regional more middle market institutions in the 2000s.
Obviously, the GFC and the time around that just expedited the
exodus from the corporate lending business for commercial banks.
That disintermediation is not a new thing.
I think what you've seen over the last few years is a number
of private credit partnerships with commercial banks.
I find it interesting.
Obviously, we've announced one of those partnerships with folks
at PNC, which is the sixth largest bank in the country, and a
very active partner of ours for really almost 20 years now.
I'll try to speak generically of these partnerships.
I think they're interesting, and I think
they're interesting for a number of reasons.
Number one, it's clearly the banks attempting
to stay relevant to their client base.
Because of the regulatory hammer, if you will, they've had a
harder time providing lending and capital to their client base.
They're still providing very necessary services, including
cash management, hedging, advisory services, et cetera.
But that lending tool has been something that's
been a little bit harder for them to provide.
Their relevancy becomes harder, and they have a very attractive client base.
There's a variety of ways these partnerships
will work, and I think some will be successful.
Some will probably be challenged in how they go to market and execute.
But by and large, I think investors should look at those and consider them.
If you think about the private credit middle market, it's
80% to 85% dominated by private equity-owned borrowers.
That has been the dominant source of both demand for
capital and demand for private credit since the GFC.
There are probably a dozen or so lenders in that part of the market that
focus on private equity borrowers and really have a big market share.
They have great relationships.
They're large AUM players, and they're not going anywhere.
And I think for investors, what they're going to see is that same
go-to-market process, very limited diversification for them.
And if it's not just the same process, probably more importantly,
you're seeing increasingly more and more overlap in portfolios
amongst the folks that dominate that part of the market.
And I think if an investor wants to expand their private credit
bucket, want to grow, and certainly if they want to diversify,
they need to look outside of that private equity-dominated lane.
I think these bank partnerships provide that alternative.
One, it's the advantage of incumbency that the bank relationship brings you.
That's a tremendous advantage when you're in the lending business.
Two, it's a relationship that's many times 10, 15, 20 years long.
There's some loyalty.
There's an inertia of changing banks and bank relationships.
There's a sense of continuity and consistency that those
borrowers, those institutions, would rather maintain.
And then maybe just as importantly, you have a whole volume
of non-sponsor relationships that that bank has that
will never be bought by private equity sponsors.
I think investors would be well-served to consider
this differentiated origination platform opportunity.
Rick, as you mentioned, direct lending emerged as an
asset class following the global financial crisis.
We've seen a lot of developments in the market over the past 15 years.
Are there still opportunities out there, or is this just a beta trade?
I certainly think that there's opportunity out there.
I think what you're seeing in the middle market private credit space is
the evolution of the asset class, the maturation of the asset class.
We're coming off of this period, I said earlier, of low
rates and recession-free economic backdrop, no defaults.
It's really been a great beta trade, to use your term, and it's done well.
And I think now, as you see interest rate volatility, economic uncertainty, and
the aging of the asset class, you're going to finally begin to see a dispersion
of manager returns and performance and the ability for investors to
delineate which of the managers they want to be with
and the ones that maybe they don't want to be with.
But two things can be true at one time.
You can have a vibrant, attractive, new issue market within private
credit, and you can also have issues and problems to deal with.
And I think just with the rate rise alone and the really aggressive lending
activity that took place pre-COVID and then again in '21, has created
the opportunity for a stressed or distressed strategy
to be executed successfully within private credit.
So I think it's because of the evolution of the asset class,
and as I said, the maturation, you now have both of these
kind of investment opportunities for investors to consider.
And that's not unusual.
There's all kinds of other asset classes that you have both a vibrant new
issue environment as well as a distressed opportunity set at the same time.
And I don't think private credit is any different in that regard.
Remember, we're non-traded bank debt.
It's been around for hundreds of years.
It's not going away.
These borrowers really don't have a lot of other choices in terms of types of
capital they can attract, and they are very consistent consumers of capital.
So from an opportunity standpoint, I think that's a steady,
that the answer is it is a steady ongoing opportunity.
I think maybe the real challenge going forward is that with that end of what
we refer to as the beta trade, manager selection finally matters, right?
It pains me to think that it hasn't mattered in all these years that we've been
doing it, but it probably more so now than ever is important to look at track
records in history and dealing with underperforming businesses and really a
single one objective we have, which is to mitigate and avoid
principal loss, mitigate risk and minimize principal loss.
You do that as a manager, you can have a franchise,
a platform, a business for as long as you like.
And so I think investors are finally going to have the ability to
discern between manager quality, given that we're probably moving
into more of a normal environment than what we've come out of.
Rick, thank you for joining me today for TCW's Investment Perspectives podcast.
For more information on TCW strategies, please visit our website at tcw.com.
Thanks for listening, and we'll pick up next time exploring
the trends and opportunities shaping global markets.
Thank you for joining us today on TCW Investment Insights.
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