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The role of credit in private finance
CVC Portfolio Manager Pieter Staelens has been featured in LPeC's 2020 Annual Market Review discussing the role of credit in private finance. The full report is available on the LPeC website.
The world of private finance mirrors the public markets in lots of key ways. Companies issue shares and borrow money, and provide investment opportunities in the process. Listed private funds provide the gateway to this world.
Private equity may be better known, but the private credit market is much bigger than many people realise and fulfils a really valuable role in the financial ecosystem – providing both much-needed debt finance to companies held in private equity portfolios and stable income to investors at levels much higher than is available on cash savings or by buying investment-grade bonds.
When a company held in a private equity fund makes an acquisition for example, it will usually finance the deal with a mix of new equity and loan finance. On average, loans or bonds make up around half the package. Similarly, private credit funds help finance management buyouts. This helps explain why the debt markets are similar in value to the private equity markets. There are, however, relatively few listed private debt companies compared to private equity counterparts, so these type of funds, such as one CVC Credit Partners manages, CVC Credit Partners European Opportunities Limited ("CCPEOL"), play an important role for investors who are interested in private finance and who may need an income that they can't earn elsewhere.
Most importantly, CCPEOL aims to select companies with stable cash flows, rather than cash-hungry startups. We believe this is necessary to provide stable income to investors and it means the sector mix is a bit different from many private equity funds, which is also good for investor diversification. CCPEOL's portfolio has two main elements. The first element we focus on is to invest in stable assets like healthcare and software that may generate reliable cash and which have so far proved very resilient in 2020's crisis. The second element we look at is opportunities to buy debts at distressed prices and so make capital gains either when prices recover due to improving credit conditions or a more settled macro environment, or through a resolution process. CCPEOL really gets under the bonnet of the companies whose debt we buy in order to have a better understanding of their finances than credit rating agencies often do - that presents real opportunities.
People often ask whether default rates on loans in the portfolio are high, assuming that private finance is much riskier. It’s true that the debt CCPEOL buys is sub-investment grade and therefore considered riskier, but this question misses the point. We may buy the debt of a company at a discount to par (the original face value of the debt) because we believe there is sufficient value coverage to recover par, even if this means the company defaults. The 4.5% steady dividend (as of 6 October 2020) paid to CCPEOL's shareholders testifies to its ability to deliver a consistent return, even after any loan losses which might occasionally be suffering. The listed structure also means the dividend can be smoothed over time so the investors can be confident that their income will generally be pretty stable.
This stable income helps reduce the volatility in the share price though like any listed vehicle, prices can move around a lot in the short term. A big advantage is that CCPEOL publishes its net asset value every week. Unlike private equity, the debt bought is liquid and prices are readily available so the published NAV is up-to-date all the time. That level of transparency may reassure some investors during uncertain times.
Looking across the wider market in 2020, far fewer companies are defaulting on loans than in the GFC a decade ago. Default rates are 80% lower in the European leveraged loan market (source S&P) for example, thanks to high levels of government support and a still well-functioning banking system. We don’t have a crystal ball, of course, but over the next few months we are alive to the risks and opportunities presented by the second wave of the pandemic, the US election and Brexit. The credit markets are open.