As early- and late-cycle indicators conflict, Neuberger Berman analysts suggest investors turn toward private debt — senior loans to private-equity-backed companies.
According to a report from the investment management firm’s co-heads of private credit, Susan Kasser and David Lyon, investors are facing a central paradox in the market. Early-stage predictions show growth is coming in the near future, a signal to investors to put money to work. In fact, given all the government monetary and fiscal stimulus as well as progress in vaccinating the public, the Federal Reserve is forecasting U.S. GDP to be 7 percent larger in 12 months and 3 percent larger than it was before the Covid-19 pandemic shut down economies around the world. But valuations are extremely high, the mark of a mid- to late-stage economic cycle that is pushing investors to be risk averse.
“The early-cycle, recovery-scale growth prospects would normally be a clear incentive to seek out investments and deploy capital. But we believe later-cycle valuations, with their implied downside risk to multiples, are enough to give serious pause,” according to the report.
Still, for Kasser, the risk aversion is a reflection of investors’ myopia. Instead, they need to dig in and look at other metrics to assess whether or not investments make sense.
“When investors are looking at equity, they complain about valuations being too high, and when they look at credit, they complain about yields being too low,” she told Institutional Investor. “But what I’m saying is, when you’re lending to a company like, yes, you’re the debt so you should care about the yield. But you should also look at measures of risk, like total leverage and loan-to-value. And so the fact that the equity valuations have gone up means your loan-to-value has gone down.” A lower loan-to-value ratio is good for investors as they’re lending against more value.
According to PitchBook data included in the report, the median enterprise value-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio for U.S. buyouts went from 10.5 times in 2015 and 12.3 times at the end of 2018 to 13.2 times by the fourth quarter of last year.
“So what that actually means is that if leverage that gets you the job is the same and the purchase price is higher, the loan-to-value is lower, which is one way to measure the riskiness of a loan,” Kasser said. “That’s a pretty good sign.”
PE firms are also buying high-quality companies, particularly in the healthcare and technology sectors, a move that reduces the risk to investors lending to the companies. According to Kasser, PE firms aren’t interested in fixing things broken by the pandemic; they want to buy high-growth assets that were unaffected by the trials of the past year.
“In this environmental with this paradox, one of our arguments is that you should be doing loans to these private-equity-backed companies because loan-to-value is down and forward prospects are great,” Kasser said. “So, actually, the risk-return continues to be very attractive.”
