Disclaimer: The information and materials prepared are for internal use only and on how the Dancap Family Investment Office (“Dancap”) views current market dynamics. Dancap does not guarantee the accuracy or completeness of the material and it is not intended in any manner to be investment, financial, legal, accounting, tax or other advice and should not be relied upon.
Dancap's Current Private Debt Strategy
Dancap has over 20 years of track record investing in private debt through third party fund managers and co-investments. This market overview focuses on Dancap’s private debt holdings as they relate to our current investment strategy and geographic allocation and looks to provide an update on current market dynamics, outlook, and future risks.
The majority of Dancap’s private debt portfolio is currently comprised of third-party managed funds focused on US senior secured, floating rate, sponsor-backed, corporate lending strategies. With modest use of leverage, this strategy can offer strong risk-adjusted returns, downside protection, and stable income, particularly in a rising interest rate environment. Our private debt managers have deep track records across market cycles and look to team up with sponsors who have demonstrated expertise in their fields.
A smaller portion of our private debt portfolio is comprised of third-party managed funds in the United Kingdom (UK), targeting senior secured, non-sponsored, small and medium sized enterprises (SME). These loans can include modest origination fees and equity warrants, which provide additional upside potential to compensate for additional risk.
In general, our senior secured lending strategies target minimum returns of net 10% IRR, while our second lien and mezzanine strategies target minimum returns of net 15% IRR.
US Private Debt Strategy
Elevated inflation persisting around 40-year highs in the US has caused the Federal Reserve to aggressively hike interest rates, raising the possibility of a recession in the US. The Fed Funds Rate has increased to 3.0% from 0.0% so far this year, with investors projecting a further increase to 4.5% by year-end 2022. The Fed is forecasting 0.2% GDP growth in 2022, below the long-term trend of 2% – 3%, and strategists assign roughly a 50% probability to a recession over the coming 12 months according to a Bloomberg survey. Despite this, US unemployment remains at 3.7% (as of August 2022), near 50-year lows, wage growth is 5.5% (as of August 2022) and S&P 500 companies are projected to generate 8% EPS on the year.
Standard & Poor’s is forecasting default rates to increase from 1.4% in June 2022 to 3.5% by June 2023 (see image below, chart on right) on the basis inflation remains high, consumer sentiment is falling, and floating-rate borrowing costs continuing to rise. However, the forecast of 3.5% remains below the long-term average of 4.2% as issuers have built up large cash reserves since the 2020 recession and refinanced debt with very favourable terms. S&P’s pessimistic scenario sees default rates rising to 6.0% from 1.% which they see occurring if the US enters a widespread, deeper, or longer recession which could be further exacerbated if inflation were to remain high, forcing the Fed to keep rates elevated longer than currently expected.
Fitch Ratings raised its U.S. institutional leveraged loan default forecast by 25bps to 1.5% – 2.0% for year-end 2023 to reflect recessionary concerns, above the forecast 1.5% default rate in 2022. Fitch’s projected 2023 default rate is the third highest yearly loan default volume on record, although still well below the totals in 2009 and 2020. Per Fitch, “building materials, leisure/entertainment, retail and healthcare/pharmaceutical could finish with default rates well above the 1.5% – 2.0% forecast”. Fitch believes the 2024 default rate could rise to 2.0%+ if the challenging economic backdrop drives downward migration. (Source)
US Private Debt Outlook
Despite economic uncertainty, demand for US private debt remains robust. Buyout firms are increasingly looking to private lenders to finance their deals as the flow of high yield debt and leveraged loans has fallen. Compared to the year before, leverage loan issuance is down 21% and high yield debt issuance by private equity-backed companies has fallen by 68%. The pullback has been driven by geopolitical uncertainty, the Fed’s rate hiking campaign, and an outflow from leveraged-loan funds (source)
United Kingdom Private Debt Strategy
UK CPI was 9.9% in August 2022 and the Bank of England expects CPI inflation to rise to 13% in Q4 2022 and remain at elevated levels through 2023. As a result, the Bank of England has hiked interest rates from 0.25% to 1.75% so far in 2022 with investors expecting rates to rise as high as 3.25% by year-end 2022 and to 4.0% in 2023. Despite aggressive interest rate hikes from the Bank of England, the labour market remains strong with unemployment rate at 3.6% in July, the lowest level in about 50 years, with the BoE expecting the unemployment rate to increase to 4.4% in 2023 and 5.5% in 2024. Per the Bank of England’s August 2022 Monetary Policy Report, UK real GDP is expected to be 2.5% in 2022 and 1.0% in 2023, with the Bank of England projecting that the UK will enter a recession beginning in Q4 2022. The BoE expects real household income to fall sharply and consumption growth to turn negative in 2022 and 2023 due to the cost of living crisis caused by inflationary pressures and energy crisis.
United Kingdom Private Debt Outlook
The outlook for UK private debt managers is deteriorating driven by the increasing likelihood of a recession. Ernst & Young is forecasting loan defaults to rise from 2.6% in 2022 to 3.9% in 2023, a five-year high yet lower than the previous peak of 8.4% seen in 2013 during the Eurozone debt crisis (source). According to the European Central Bank’s Bank Lending Survey (July 2022) (source), there is a net tightening of credit standards on loans to companies, especially to SMEs, as monetary policy is becoming less accommodative, creating a void that private lenders are addressing. Unlike the US, the opportunity presented by bank retrenchment is still new with only 35% of loans to European SMEs coming from direct lenders while that figure in the US is 80%-90%. Therefore, the UK market remains less competitive than the US, meaning private lenders can be extremely selective and borrowers are more accepting of stronger covenants (Source: Crestbridge).