Current Credit Market Trends with HPS Governing Partners Purnima Puri and Mike Patterson

Colbert Cannon: Hello, and welcome back to Season 10 of the HPScast. I’m your host, Colbert Cannon. If you’re new to the pod, HPS is a global investment firm that manages more than $100 billion in assets for a broad range of institutional and retail investors. That capital is invested across private credit and public credit strategies.

This week, we have a special episode where we’re going to speak with two of HPS’s governing partners about current credit market trends. Joining me today is Purnima Puri, who leads our public credit strategies, and Mike Patterson, who leads our senior private credit strategies. Thank you both for joining us.

I’d like to start with the relationship between private and public credit. Since 2008, private credit has grown from quite a small asset class to a roughly comparable size to the broadly syndicated market. Both have grown materially, but private credit has clearly taken market share.

Mike, maybe we’ll start with you. What’s been the interplay between liquid and private credit markets in recent years, and how do you see that evolving going forward?

Mike Patterson: I think it has evolved a lot, and I think the driver for the evolution over the course of the past four or five years has been the capacity of the private markets to provide a complete solution in larger and larger situations.

There’s always been an advent of flow, and I think the public markets react more dramatically to changes maybe in macroeconomic prognostications. But if we look over a several quarter period, I think there’s a general sense of equilibrium between the public and the private markets.

There are times when public markets are more aggressive. I think the private markets tend to be open in times of stress, where the public markets tend to be functionally closed in times of stress, but that quickly fixes itself, once those periods of dislocation resolve. But I do think the biggest change is the equilibrium used to just be at the lower end, from a scale perspective, of the public markets. And I think now that equilibrium exists, not just at the extreme lower end of what the public market will finance, but maybe in the middle from a non- investment grade perspective, the middle as measured by scale.

Just because it’s a round number, you know, the billion-dollar transaction, if we looked at it five years ago, I don’t think private credit was a credible competitor to the public markets. And now it’s a credible competitor. And so, an equilibrium exists. And, you know, there are quarters when that’s 3% or 4% of stuff being done in the private markets, and the rest of it done in the public markets. And there are quarters where it’s 25% of stuff being done in the private markets relative to the public markets.

But it’s not zero for the billion-dollar potential loan, and there was a period of time when it was.

Colbert Cannon: All right, so Purnima, when you think about it from a borrower’s perspective, in terms of accessing either liquid or the private credit solutions, what are factors that would make you push in one direction versus the other?

Purnima Puri: I think first, Mike touched on this, the openness of the capital markets and whether they can access the broadly syndicated loan market, is important to borrowers, mostly because, oftentimes, the spreads are tighter than private credit. And even in the world that we’re living in today, they continue to be tighter, and those spreads range from call it 150 to 200 basis points. So, query one is, are the capital markets open and can you issue? I think with regard to what we’ve seen from borrowers and even in today’s market, there’s a variety of things that are important.

So, one is, a rating is super important. You know, can a borrower access the liquid market? 60+% of that buyer base are CLO buyers. That is a ratings dependent market. Many are insurance companies, also a ratings dependent market. And I would actually say that’s relevant for the moment in time you’re in as well, as opposed to looking at a credit over a cycle, because that rating may change.

Two is speed of execution. In a year like 2023, private credit refinanced 34 deals, $27 billion of par value. So, Mike alluded to, sort of, the push and pull here. This year, the liquid markets have refinanced 28 deals and $9 billion of par market value. So, you know, you see it, sort of, going back and forth, and it turns out those numbers are roughly aligned in terms of the par value if you were to annualize it.

So, ‘23 and ‘22 when the markets are a little bit frozen, private credit can offer a solution much more quickly in some instances. There may be flexibility that a borrower might need – some PIK toggle features, portability features are important, delayed draw for acquisitions to build a business over time. Oftentimes, those are things that private credit can provide that liquid credit sometimes can’t.

Mike Patterson: Yeah, I always think of it as, the public markets have a very narrow, well-defined box, and if you fit inside that box, it is the cheapest and most efficient way to finance your business. But if you need something outside that box, the public markets, most of the buyers being CLO buyers, as Purnima said, they don’t have the capacity to provide that flexibility. So, the private credit world can work around the company’s needs in a way that the public market maybe can’t. But if you fit within the narrow box that fits the public markets, it’s the cheapest way to finance your company.

Colbert Cannon: Let’s talk about documentation. So, docs have weakened in the liquid credit markets for many years, leading to a rise in liability management exercises and defaults. But in the last two years, you saw public lenders gain a bit of the upper hand. Documents tightened back a bit. Private credit historically benefited from tighter docs, but with so much capital raised, some private lenders were willing to forego strong creditor protections. With the markets on the liquid side open, at least for high quality issuers, and so much dry powder in private credit, will the pendulum swing back towards looser documentation?

Purnima Puri: I think probably yes. So, a couple of things. The first is that this year, the new issues have been predominantly – I think the number is 67% – refinancings. So, it hasn’t been core new issuance.

The second is a lot of it has been much higher quality issuers. So, the minute you get into the higher quality issuers, you’re going to actually see looser documents in the same way if you take the extreme investment grade documents, they are the loosest documents in the bond market. So, you’ve definitely seen that.

What will be interesting to see is when the market opens up for the lower quality issuers, whether or not the buyer base will be able to continue to push for tighter protections or not. But really what we’ve seen this year is much more higher quality issuance.

Mike Patterson: And I completely agree with the likely trend. We have to look at supply and demand. And in this case, it’s the supply of potential lending opportunities and the demand for those, meaning how much capital has been raised, both on the private side and the publicly traded side.

You know, M&A volumes still are a fraction of what they were going back to 2021. I think a lot of people expected a really robust rebound in the first half of 2024, and that hasn’t materialized. Is it up year-on-year? Yes. But has it returned to the previous equilibrium levels? The answer is no.

And so, refinancing has been a huge theme. New M&A lending has been less active than people anticipated. One of the ways that capital can make itself more attractive is to give people more flexibility on the document. So, I agree with you. I think we will see that.

But I also think that people have focused on things that matter. You know, these documents are 350 pages long. There are a borderline infinite number of things you can argue about and negotiate. But I think there are a finite number of things that actually matter when a business doesn’t go according to plan, and I do think that people’s spines have been stiffened over the last two years about things that matter.

Colbert Cannon: And what are those like?

Mike Patterson: To me, the two that matter most is the ability to add incremental debt even when a business is underperforming, and the ability to move the pieces around the chessboard, specifically, to move collateral away from the original secured loan that was secured by that collateral. And one is, if we think of a recovery after a default as a numerator, meaning the assets you recover on, and the denominator is the amount of debt that’s recovering on those assets, those move both those numbers. And in the really extreme circumstances, there are more people recovering on less collateral, and that really affects recoveries. So, holding the line on some of those critical issues, I do think people’s spines have been stiffened over the last two years. But I also think the overall trend of docs is not getting progressively tighter through 2024. I actually think it’s getting more permissive.

Colbert Cannon: You know, you as portfolio managers think about risk in the portfolio all day long. Can you talk about some of the macro risks, things you pay attention to and worry about, both for the overall market and for individual portfolios?

Purnima Puri: Sure. So, I think the first is everyone’s been all eyes on inflation. That’s been the theme really since the end of 2020. And in the world of the liquid markets, one of the big things we’re always watching is the rate environment and what that means in terms of allocations between loans and high yield, between investment grade, CLO debt, et cetera.

We came into the year with the market pricing six or seven cuts. The market is now taking that down to two cuts because we’ve continued to have some reads where inflation moderating is tempering, and we need some more indicators to see where that might land.

And I think, as a result of that, you’ve heard the rhetoric of higher for longer. We do think that’s true. We think that you may see some cuts. That may be one cut. It might be two cuts, but it’s unlikely to be 3+ cuts. All of that’s driven by inflation.

And when we think about that, we’re really pretty focused on what that means for, sort of, medium-term bonds and high yield bonds. And our view is that it’s very difficult to get 10-year treasuries much below 4% for a variety of reasons. One is that the Fed has said we want real rates north of 2%. Two is that you have less buyers, so the technical dynamics are not your friend. And I would say three is, there’s one risk that’s creeping, and it seems to be people aren’t focused on it as much as maybe they should be, which is the federal deficit. And there’s a lot of mega trends that are spend-oriented and inflation-oriented: deglobalization, defense spending, transition to green economy, et cetera. And so, we’re pretty focused on that in terms of the broader macro risks, I would say in the market.

Mike Patterson: And I think when we try to risk-spot at a granular level, in the private credit portfolio, there are two things that we’re wary about. I think if you had told me in 2022 that we would be two years into an inflationary environment with rates north of 5%, and we had not seen significant profit margin degradation in the portfolio, I would have said that was highly improbable. That’s what’s happened. I think the underlying portfolio companies that we observe, and I think in our conversations with other people in the private credit space, we’ve all been pleasantly surprised by how nimbly management teams have navigated this environment.

They’ve flexed their cost structures, but in particular, they’ve passed through inflationary supply prices on their top line, and that’s actually, in some cases, expanded certainly dollar profits and held profit margins. So, I think an exhaustion of that ability to raise prices, which maybe is another way of saying the inflationary environment starts to reach an asymptote – the ability to pass them through, and we do see profit margins starting to decline – I think that is underpriced on the market and underappreciated. And I don’t think it stretches the imagination in a world of higher rates to see that happening – the inability to ultimately pass through higher prices starting to hit the corporate bottom line.

And then the second, and maybe this is very specific to the world of private equity lending, is one of the dominant strategies over the course of the past decade in a world of really low rates and ample liquidity in the credit markets has been the private equity roll-up: the ability to pay pretty handsomely for a platform and then build equity value over time with debt-funded acquisitions. And I think that strategy works in most macro environments, if you have decent organic growth in the underlying platform – if the underlying business really exhibits some positive, and they don’t have to be wildly positive characteristics, but it is a GDP or GDP plus organic grower. But that strategy works in the macro environment of the last decade even with no organic growth. You can manufacture organic growth with really cheap, debt-funded acquisitions with low base rates and low spreads, and those have been successful for a decade. I think some of those platforms, which are quite large and have huge debt facilities supporting them, woke up in 2022 and their cost of financing went up 500 basis points over the course of three quarters. And we look at them and say, this company, which has been successful for a long period of time, we don’t think they return the cost of capital. And I don’t think that’s been processed in the debt communities, sufficiently.

Colbert Cannon: So, let’s talk about the maturity wall. Over the last 15 years, anytime there’s been any market volatility or stress, people talk about the maturity wall and raise the human cry that it’s going to be a problem, and it’s never once really mattered. But for the first time since 2007, we have higher interest rates, and for many borrowers, you just have a math problem. You’ve got a quantum of debt where suddenly, per your point, my cash interest expense just gets too high for existing debt levels. How will refinancings in the coming couple of years be managed given the new breadth of options we have in front of new borrowers?

Mike Patterson: So, I do think it’s going to require some creativity. I think the math problem in terms of interest coverage is real. In some of these situations, the answer is that you need to inject more equity and pay down the debt stack and then you have a refinanceable quantum of debt that the new equity can also be new junior debt.

And I mean, I think there’s a very real need and a very interesting application of subordinated private credit, and it’s in the capital structure of something that is currently over levered, taking a subordinated position, being able to mix cash pay with payment in kind (PIK) so that the company can deal with its overall debt load, and then maybe have a senior piece that is now refinanceable in the public markets at a reasonable or even attractive spread to the company. I think that is something we’re going to see more and more of – so, the ability of private credit to play a creative role or refinance the entire cap stack and blend those two. So, I think that’s one option.

When I look at the maturity wall, if I were a CFO, for some reason, it seems like the world has decided that a maturity wall should be measured over the course of the next three years of how much matures, and I just don’t think that captures any sort of time pressure. I think the real maturity wall is the next 12 months. Over the next 12 months, when there’s an excessive amount of debt due, then there’s a “pig in the python” problem of trying to solve all those at the same time when the market might not be receptive.

We saw that in 2023. I think, before the public markets became more receptive to low single-B issuers, there was a real problem in 2023. And a number of those refinancings required creativity. But I think the market that we’re in today, it’s going to be a mix of a public and private solution in order to deal with the refinancings.

But it is not a wall. Like, it’s not. I think there was a period of time when we thought there was, but the market tends to resolve this in a really rational way.

Purnima Puri: I agree with Mike on the maturity wall. I think it’s been, sort of, 5% matures every year or something like that in the history of time as far as we can remember, and maybe it’s 7% or 8% now, so, I don’t think it’s so dramatically different.

But what I do think you’re going to see, which I think is interesting in the liquid markets moreso, is shortening of duration. I think the way that if you’re a CFO and you’re looking at capital structures and you say, gosh, whether I’m an investment grade company or even a high yield company, what can I do to allow myself to have the optionality to refinance into a lower rate environment in the future? The shorter duration is better, and you’re actually seeing that.

So, the investment grade index has shortened a lot from roughly 8.8 years to 6.7 years, and the high yield index has shortened. If you look at the high yield index, it’s shortened from six years to under five years, so it’s about 4.8 years. So, I do think you’re going to continue to see lower issuance in long duration because, if you’re running a business, you want the option to refinance lower when rates come in.

Mike Patterson: And that’s because the lower duration comes with shorter call protection? So, you’re back in the window of being able to do it costlessly?

Purnima Puri: So there’s the call protection, which your point is exactly right. And then the second point is just the ability to say, hey, I’m going to do a five. We saw this, for example, when spreads were wide in COVID. We saw a bunch of five-year bonds for really good, crossover type credits, as opposed to 10 and 15-year bonds that you might have seen historically.

Mike Patterson: Just from the CFO’s perspective, it’s like, okay, I think this spread is artificially high, and I’ll deal with it for a short amount of time but not a long amount of time. That makes sense.

Colbert Cannon: So, let’s talk about default rates. If you go back to the Global Financial Crisis, default rates spiked out in the leveraged loan environment at around a 14% rate. For the last 15 years, it’s been between, sort of, 2.5% and 3%, with moments of episodic stress where energy and power companies filed, where retailers restructured but it was generally benign. Given the number of macroeconomic risks and the rate environment, let’s start with you Purnima, what do you see in the public markets for expectations for default rates in the near-term?

Purnima Puri: So, I think people have shifted their expectations a lot, and we don’t see a massive tick-up in default rates going forward. We’re seeing some degree of tick-up, but a lot of it is going to be dependent on what Mike alluded to earlier in this conversation, which is, can people continue to pass through price, and can people continue to maintain their margins? Because, for the most part, companies have hung in there.

You’ve seen an uptick in defaults. You’ve seen an uptick in liability management. We’ve talked about that already, but in terms of actual default rates, there’s not that many maturities in the next 12 months. So, that’s first of all and most important.

The other thing I will say with regard to default rates for those companies that have a longer maturity is you are seeing more of the liability management, which we talked about, and that’s allowing companies to, sort of, kick the can for a little while and keep playing through in ways that may not be so lender friendly, and that has actually prevented a lot of defaults that we would have seen at a different moment in time in the markets.

Mike Patterson: And I think also changes the path. I mean, I think we need to evolve the conversation around defaults to one around losses, because I think we have changed the nature of underlying debt. It’s become much more complex than what used to be a loan. Now there are six different types of that same loan, and they have different risk characteristics. And that’ll be expressed in different losses when something defaults.

So, it used to be, I think, a statistically defensible pattern to just talk about defaults and assume that recoveries were about 70 cents on the dollar. That was true over a long period of time, and there were periods where it was lower and maybe it was 50 or 60, and periods where it was higher and maybe it was in the 80s. But that 65 cent, 70 cent recovery for first lien senior secured loans, there was a lot of strong data saying that as a measure of central tendency – it was defensible.

I think we might have broken through that as a defensible average. And the statistics will have to prove whether this point is right or wrong, but talking about risks, Colbert, in the credit markets in general, I worry that our mindset has not shifted into one where we’re talking about losses and seeing the severity of losses for each default significantly higher than we have in historical periods. So, a weakening in documentation after a decade of a reasonably low default rate means that documentation, when it’s leaned upon to defend a credit, is a lot less effective. And so, we see recoveries 30 cents and 40 cents, not 70 cents, so that the same default rate is twice as bad when we look at losses. I think that’s one of the things that we are concerned about from a risk perspective.

Purnima Puri: And I’d say, just to add to what Mike’s saying here, on the liquid side, you’re actually seeing companies where, in those liability management transactions and those, sort of, “left-behind lenders” as they like to say, that paper might be trading sub 50 cents and not defaulted. And when we started doing this a long time ago, you didn’t see that.

Mike Patterson: That was almost mathematically impossible, historically, because anything trading at 50, there would have been a covenant that was about to be breached, in which case you could drive it to trade north of breach, so it should have been worth more than 50. So, I agree. That’s a unique phenomenon in the history of the credit market. So, the trading prices are starting to reflect it.

I mean, the nice part about the public markets versus the private markets is, let’s say there’s a really good company where you think the probability of default is very low relative to the average probability of default. You can own that. Things in the industry could change. You could conclude you were wrong, and you can sell it. So, you don’t have to necessarily rely on the document for recoveries. You can actually price a weak document relative to a really strong business and decide that it’s still a good investment. Whereas on the private side, we will live with those mistakes, and we will be part of the workout because we can’t really rely on liquidity as an element of risk mitigation in any efficient way.

So, I do think you might see a separation of the markets even more from what we have to do on the private side, from a documentation perspective and what you can do on the public side, because you can use liquidity as a way to actually manage that risk.

Colbert Cannon: Thank you, Purnima and Mike, for all of your insights, and thank you all for listening.

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