Private Credit – Adult Swim Only: 2016 Mid-Year Update By Henry H. McVey, KKR
We stick to our base case that we remain in an “Adult Swim Only” investment environment, as we see more asynchronous growth ahead. Against this backdrop, however, we still see significant opportunity. Private Credit has emerged as one of our favorite investment ideas in today’s current environment of low rates and uneven global growth. Not surprisingly, we also favor Real Assets that can deliver yield and growth, and our research suggests Private Equity is likely to outperform Public Equity at this point in the cycle. We are not advocating huge sector and style bets at present; rather, we would focus on opportunities where quality assets with complexity are trading at discounts to their intrinsic values. By comparison, we are growing increasingly concerned about the valuations of defensive and certain growth-oriented assets.
From our macro perch at KKR, it definitely feels like 2016 has emerged as a year of “Adult Swim Only.” Markets have cut a wide swath so far this year, enticing investors to buy and/or sell often at what was – in hindsight – likely the time to do the exact opposite of what one’s emotional core was suggesting.
Importantly, as we have seen with recent events in the United Kingdom, there is certainly more to making good investments these days than just understanding the fundamentals. Indeed, similar to other post-crisis periods in history, we are now seeing a notable splintering of political harmony – one that extends from Europe to the United States, Latin America, and even Asia. In our view, this shift in the geopolitical landscape could be a secular, not a cyclical, phenomenon.
We are sticking to our playbook that we are later cycle, favoring idiosyncratic opportunities over beta-related plays. We still prefer Credit to Equities, and within Credit, we are most intrigued by the opportunities we see related to periodic dislocations and/or structural changes across the banking system.
As we discuss in more detail below, our bigger picture belief is that financial assets with predictable cash flows could now be overpriced in many instances. On the other hand, “complexity” (i.e., stories that lack EPS visibility or some type of industry taint) now seems to be trading at a discount, particularly in unloved sectors of the market. In our view, this discrepancy may be one of the most important arbitrages in the market right now.
Despite the negative overhang of Brexit, we are not yet calling for a recession and/or bear market. However, similar to what we laid out in our January Insights piece, Outlook for 2016: Adult Swim Only, we still see more limited upside to financial asset appreciation than in prior years – and with higher volatility. If we are right, then an investor should expect a lower return per unit of risk across most asset classes. Key to our thinking is that – compliments of global QE – many asset price returns have been pulled forward amidst below average volatility, as central banks have driven yields down to record lows. Consistent with this outlook are two important global macro trends that we believe are worthy of investor consideration:
- First, with $9.9 trillion in negative yielding bonds, we think that there are now diminishing returns to QE at this point in the cycle1;
- Second, given the recent surge in debt financing across public and private capital structures, we believe returns on incremental leverage in many parts of the global economy may have peaked and may actually be declining in many instances.
That said, global central bank policy remains formidable, and of late, we are encouraged that the Federal Reserve is now more focused on the trajectory of currencies, the U.S. dollar in particular. Key to our thinking is that the dollar, when undeterred in its movement upward, can restrict financial conditions – sometimes more than what an actual rate increase might otherwise accomplish.
With these thoughts in mind, we are making a few tweaks, though no major changes, to our portfolio in an effort to reflect our latest thinking. In addition, we are also using this mid-year update to provide some additional color on where our conviction levels have increased and/or decreased. See below for details, but we note the following:
We are reducing Cash by three percent to four percent from seven percent versus a benchmark of two percent and adding three percent to Mezzanine/Asset Based Lending within our Private Credit allocation. See Exhibit 1 for details, but our total weighting in Private Credit related investments — including both Mezzanine/Asset Based Lending and Direct Lending — moves to 13% from 10% in January and a benchmark of zero across the two asset classes. Given the shift towards negative interest rates and ongoing and intensifying regulation of the banks, we are seeing a major spike in opportunities in the mezzanine and asset-based lending areas of the global economy, Europe in particular. Indeed, some of the more interesting risk-adjusted opportunities we are seeing from a direct and co-investment standpoint are now occurring in situations where banks have fallen away as the traditional lender of choice. Moreover, many of these opportunities are occurring when volatility heads higher, not lower; as such, we like the somewhat counter cyclical component to this offering.
More than ever, we feel confident about our outsized bet across Private Credit. As we mentioned earlier, we are seeing a variety of different opportunities across Private Credit (Direct Lending, Asset Based Lending, Mezzanine, etc.), which makes us feel comfortable with an allocation that is 13% outside our benchmark and could likely lead to significant tracking error over time. Our positive rationale rests on three pillars. First, with leveraged lending guidelines now being enforced more strictly, corporate and financial acquirers must look beyond traditional financial intermediaries to support their deals. Second, there is less capital available for small-to-medium-size businesses, as banks reduce their footprints amidst shrinking net interest margins and heightened regulation. Finally, we think that current deal terms now often favor the lender, not the borrower, which is different than 12 to 18 months ago.
We are moving five percent from Distressed/Special Situations towards Actively Managed Opportunistic Credit. Without question, we are seeing attractive opportunities in niche credit markets such as closed-end funds, certain CLO assets, and periodic “hung” loans. By comparison, we think QE is denting some of the Distressed/Special Situations opportunities that we originally thought might occur at this point in the cycle.
We continue to favor Real Assets with yield and growth, but we also think that certain commodities are bottoming. See below for details, but we believe that areas like infrastructure, real estate credit, MLPs, etc., remain potentially interesting investment opportunities for institutions and individuals looking to earn not only above-market yield but also some above-average growth in the value of the underlying assets. Meanwhile, our research also shows that several commodities have corrected towards the level of prior secular bear markets both in terms of price and time (Exhibits 57 and 58). Selectivity is still required though, and at the moment, we favor oil and copper over assets with fewer supply-side adjustments, including iron ore.
We no longer see any rate increases in 2016, which also has implications for the U.S. dollar. If there is one