Investors may see tough credit cycle in direct lending: TCW Private Credit

As economic uncertainties grow amid rate hikes and inflation, South Korean institutional investors are eyeing direct lending for safer investment and higher profitability. However, direct lending should be a resilient asset class regardless of the economic environment and shouldn't be vintage-sensitive, according to Richard Miller, group managing director of the Los Angeles-headquartered TCW Private Credit Group.

Five to 10 years from now won't be like the past 12 years in terms of direct lending in the US middle market, he told The Korea Economic Daily. The last 12 years have been an attractive environment for investors, and private equity sponsors have raised a vast amount of capital for the US middle market. This has led to record-high debt-to-EBITDA ratios of enterprises and fewer restrictions in loan agreements.

Miller said these trends could become troublesome to some lenders in economic uncertainties, and once the elevated enterprise values contract investors are likely to experience a tough credit cycle. It means manager selections are more important today than over the past 12 years.

Founded in 1971, TCW is managing $243 billion including fixed income, equity and alternative assets as of end-March 2022. It manages one of the largest mutual fund complexes in the US with over $100 billion in assets under management. The firm's largest shareholder is its employees, and The Carlyle Group's fund and Nippon Life Insurance Company are minority shareholders.

The following is an edited version of the interview with Richard Miller.

▲ What is your view on current market uncertainties compared with the 2008-2009 global financial crisis and the dot-com bubble in the late 1990s?   

"There are always similarities as well as differences in periods of major market changes. The similarities include an increased optimism by investors and a relaxation of investment discipline due to the fear of missing out (FOMO) on the current opportunity."

"In the early 2000s, there was the tech bubble when investors were very excited by the potential to make money by investing in dot-com stocks. Then there was the housing and financial market bubble leading to the 2008-2009 global financial crisis, which had people leaving their jobs to buy and sell houses as well as day trade the stock market."

"Today, due in large part to the very long period of ultra-low interest rates, the amount of debt being utilized by borrowers has contributed to the mispricing of many assets. Although it can be difficult to identify a financial bubble before it bursts, this feels like it could be a financial asset valuation bubble for investors."      

▲ What are the unique characteristics of current financial market uncertainties?

"One of the key differences we see is where the potential excesses in the market reside. One of the contributing factors to the global financial crisis was the very high level of leverage in the financial industry. The high leverage created systemic risk throughout the financial markets."

"In the current market environment, we believe the risk lies at the individual corporate borrower level rather than throughout the financial system. Enterprise value multiples in M&A transactions have been at record highs and that means leverage at the corporate borrower level has also reached record highs. These conditions exist while the central banks of the world are trying to control inflation and deliver a soft landing for the economy. We have serious doubts whether that is possible."

▲ What are the opportunities in the US direct lending market?

"The opportunities are in the nature of the senior secured bank loan investment. We believe bank loans are attractive investments because they provide floating interest rates and are first-line for repayment ahead of other capital providers. If interest rates rise, investors enjoy receiving a higher rate on their loans. First lien senior secured loans sit at the top of the capital structure of borrowers, one of the safer places to be. Finally, there is the loan agreement controlling the contract between borrower and lender." 

"The loan agreement typically includes provisions that place requirements, including performance, on the borrower.  If these terms are violated, the lender is then able to reassess their position and negotiate changes, if necessary, to the loan agreement as well as to the operating strategy of the borrower. The lender may have some questions – whether to change the interest rates or charge amendment fees; whether to reduce their exposure and require a debt paydown; whether to require the owner to invest additional capital for higher liquidity and so on. If the borrower deviates from the original strategy or performance that was required in the covenant, the lender can come back to the borrower and reassess the investment."

"So, the bank loan strategy is a very attractive asset class – it should be resilient, it can weather sustained economic downturns, and most importantly, it should have a very low probability of principal losses."

▲ What are the major risks in the US direct lending market?

"We think the overriding risk to the middle market bank lending strategy is the level of optimism we see among lenders. The combination of growth in assets under management combined with investor pressure to deploy capital has many in the market relaxing terms and becoming more aggressive. You see evidence of the behavior by observing the increase in the debt-to-EBITDA ratios, which have reached record highs."

"Also, there are fewer limitations and restrictions in the loan agreements leading to covenant-lite and covenant-loose types of loan agreements. Once again, with a great deal of uncertainty related to the health of the economy, these trends could become troublesome to some lenders."

▲ What are the particular risks in the US middle market?

"Most of the activity in the US middle market direct lending segment is dominated by the private equity sponsor community. Private equity sponsors also have raised a vast amount of capital and are typically very demanding borrowers. So, this is the most active and competitive part of the lending market place and it is where borrowers must accept the most aggressive terms and conditions."   

"Another primary risk is the elevated enterprise values that sponsors are paying for businesses.  These elevated multiples may be unsustainable through a slower economic period. If the enterprise values were to contract, you would likely have a difficult credit cycle in the middle market."

▲ What are TCW’s major investment principles?   

"Our approach has been consistent during our 22 years in the market. We maintain a full covenant package in all of our loans, require higher pricing than typically seen in the market place and strive to make these loans at the same or lower risk profile that is seen in the more conventional middle market." 

"We look for borrowers who have complicated stories, or maybe in out-of-favor industries or that simply require more time and effort to understand before making the loan. We also require a lot of due diligence and monitoring to ensure that our borrowers are performing up to expectations."

"This approach that we have kept since the design of our business many years ago forces us to look far and wide for our investment opportunities. We try to travel a different path to source our deals as the primary or more conventional path is very crowded and competitive. The conventional market is where we think most of the risk lies in the marketplace today."

▲ What are the most attractive sectors for direct lending given current macroeconomic risks? And which are those to avoid?

"The most popular sectors today are healthcare and technologies, software and business services. Those sectors are where the private equity community is spending most of their dollars and they have relatively high enterprise values. They are most active, but I am not sure if they are the best risk-reward investments for lenders. There is lots of competition and very demanding borrowers."

"We tend to stay away from the most popular and active parts of the market. It is not because they are bad investments or bad businesses, but because it is very difficult for us to get our higher pricing, more complete documentation and level of diligence required in those transactions." 

"We don't typically identify sectors to avoid. We look at every individual investment with bottom-up credit analysis. The primary objective of our business is to avoid principal loss, and that is the most important factor to make our investment decisions. We accomplish this by focusing on diligence, documentation and monitoring of our loans no matter what industry segment they happen to be in or who happens to own them."

▲ How would you advise Korean institutional investors on direct lending investment in the US middle market?

"We do not believe the direct lending asset class should be vintage-sensitive. Instead, it should be a resilient asset class regardless of the economic environment. I would advise Korean investors to look to manager selection as the key to success. Asking questions like these can be helpful: How long has the manager been investing in the asset class; and what kind of experience does the manager have in turning around under-performing loans? Understanding the manager’s investment process and rationale can help investors select a manager that aligns with their risk tolerance."

"The last 12 years have been a very attractive environment and manager selection was not as important as it is now. Today, we see all of those factors discussed above begin to change – interest rates are set to rise, default rates will likely increase and market uncertainties are growing. The next five years will not be like the past decade. A manager with experience in more difficult market environments will likely be a better choice than one that has known only the last 12 years."

▲ More Korean institutional investors are considering direct lending investment today. Do you expect this trend will continue?

"I would expect Korean investors to continue to increase their investment in private credit. I think they have identified the positive attributes such as floating rate senior secured type of instruments. You can also look for an attractive return profile and maintain reasonable levels of safety. I also expect that as they begin to understand the asset class better, Korean investors will continue to move more capital into it and move out of some of the public fixed-income strategies like high yield or high-grade bonds."

Richard Miller serves as group managing director, CIO and chairman of the investment committee of the TCW Private Credit Group. He joined TCW in 2013 with the acquisition of the special situations funds group from Regiment Capital Advisors. He has over 30 years of experience in the capital markets and was previously ranked on private market news outlet Institutional Investor's All American High Yield Research Team for six consecutive years, focusing on the metals and mining sector.

Before his involvement in high yield research, he was at Chase Manhattan Bank in the mergers & acquisitions group. He then moved on to become a managing director with the high yield group. Subsequently, he became the head of high yield research at BankBoston Securities. In 1999, he joined UBS as a managing director and head of the global high yield research group. Miller received his BS from Syracuse University and MBA from the University of Rochester.


Write to Tae-Ho Lee and Jihyun Kim at thlee@hankyung.com
Jennifer Nicholson-Breen edited this article.