On 3 May 2022, the Reserve Bank of Australia (RBA) raised the benchmark interest rates, for the first time in 11 years, by 25 basis points (bps). Followed by another rate rise of 50 bps on 7 June 2022, the most significant increase in Australian benchmark interest in over 22 years. A similar dynamic has played out in the US, where the Federal Reserve increased the Fed’s benchmark interest rates by 25bps in March 2022 and then 50 bps in May 2022 - the sharpest rise in US benchmark interest rates in 20 years.
The rate rises are the monetary policy measures taken by the RBA, the Fed, and other Central Banks globally to tackle inflation. These central banks have already signaled further rate rises to control inflation. The rate rises have created uncertainty in global equity markets, leading to market corrections across indices globally. The S&P/ASX 200 index fell 4.2% in the week ended Friday, 10 June 2022, the biggest weekly decline since April 2020 and one of the largest declines since the COVID pandemic began.
This uncertainty in equity markets has also given rise to investors being interested in alternative investment strategies, with Private Debt or Private Credit taking the lead in this asset class.
Private Debt in Australia
According to InterTrust Group, private debt has grown globally by 56% since 2017, with assets in private credit funds now totaling US$1.6 trillion. Allocations to private credit have been steadily increasing over the last 2 years as the asset class is perceived as a defensive alternative to highly volatile equities, especially since markets have corrected.
The Australian private debt market has witnessed a similar surge in demand driven by the gap in corporate banking space due to the retreat of the major four banks following the global financial crisis of 2008 and later due to tougher regulations following the 2017-2019 Royal Commission into Misconduct in Banking, Superannuation and Financial Services Industry in Australia.
Lending by Australian Banks 1990 - 2022
Source: Bloomberg
Growth in Commercial Lending by Australian Banks 1990-2022
Source: Bloomberg
Private debt strategies comprise investments in senior secured debt, mezzanine, and subordinated debt across leverage finance, opportunistic debt (growth financing), stressed debt and distressed debt.
Source: Bloomberg
Our analysis of returns by various investment strategies by investment funds with the vintage year of 2018 shows that private debt and private equity strategies outperformed returns from S&P 500 and ASX 200 indices over the same period.
Given the uncertainty in equity markets due to inflation and fear of overvaluations, investors globally are attracted to Private Debt primarily due to its features of diversification, income stream, cash yielding product, inflation hedge, capital preservation due to seniority in the capital stack ranking above unsecured debt and equity, and its low correlation to other asset classes.
Market Opportunities
As inflation hits input prices, global logistics challenges continue to negatively impact the working capital positions of many corporates across a variety of industries and sectors, thereby affecting their credit worthiness.
The prolonged period of historically low interest rates has meant that all investment and most non-investment grade companies have become accustomed to low costs of debt. This has remained the case across investment and non-investment grade credit. For example, according to Bloomberg, the average coupon on CCC-rated bonds issued in Q1 of 2014 was approximately 8.50% p.a., almost 50% below the same figure in Q1 of 2004. The rising interest rates could cause some corporates to breach interest ratio covenants, requiring them to either cure the impending breach by deleveraging their balance sheet or refinancing their existing debt facilities.
Rising input costs are also likely to affect debt to EBITDA credit metrics, causing dislocation in the primary and secondary credit markets. It is likely that companies in this position will require assistance and we believe this will lead to a surge in our deal pipeline (on top of Arbitrium’s current c.$400m deal pipeline). Arbitrium is uniquely placed to assist such companies through bridging finance, capital restructuring and unlocking values through operational turnaround.
Additionally with senior secured positions Arbitrium can generate cash yield of 10%-13% p.a. with additional upside from instruments such as equity warrants, convertibles and milestone-based cash payments.
It must be noted that the long period of low interest rates have also sustained a number of zombie companies. Therefore while there may be opportunities in the private debt market, credit funds will require a sound credit assessment process to differentiate between well-run companies facing worsening external environment vs zombie companies. Arbitrium’s credit assessment highlights companies with strong fundamentals and business model that are negatively impacted by external factors.
About Arbitrium Capital Partners
Arbitrium invests in special situations debt transactions in opportunistic, stressed, and distressed debt to mid-market corporates domiciled in Australia & New Zealand with an investment size of $20m to $80m per transaction. The team at Arbitrium is well experienced in funds management, M&A and turnaround management and have a strong track record, having been involved in some of the largest special situations transactions in Australia & New Zealand.
The Arbitrium fund offers its investors a running cash yield and enhances the net returns for its investors through instruments such as warrants, convertibles, and milestone-based cash payments.
Disclaimer
This information is provided by Arbitrium Credit Partners Pty Ltd ACN 644 484 659, holder of an Australian Financial Services Licence (No: 532796).
This is general information intended for public circulation or publication or for the use of any third party. It does not take into account personal objectives, financial situation or needs. Before acting on this information, investors should consider its appropriateness based on their person circumstances, obtain a copy of the relevant offer document, and consult their investment advisor before doing so.
Numerical figures have been subject to rounding. All amounts are in AUD, unless indicated.
Past performance is not a reliable indicator of future returns. Certain information contained herein constitutes “forward-looking statements”, and because of various risks and uncertainties, actual events or results or actual performance may differ materially from the events, results or performance reflected or contemplated in such forward-looking statements.
The market commentary reflects Arbitrium’s views and beliefs at the time of preparation, which are subject to change without notice. No representations or warranties are made by Arbitrium as to their accuracy or reliability. To the extent permitted by law, no liability is accepted by Arbitrium for any loss or damage as a result of any reliance on this information.
This report is current as of June 2022 unless otherwise indicated, and subject to change without notice.