Current Credit Market Trends with HPS Managing Directors’ Vikas Keswani and Scott Crocombe

Colbert Cannon:  Hello and thank you for joining us on today’s webcast. We’re going to discuss current credit market trends. And I’m joined today by two of my colleagues, two of HPS’s senior investment leaders: Vikas Keswani, Head of North American Specialty Direct lending and Scott Crocombe, a Managing Director and Head of Research on the HPS Liquid Credit team. Thank you both for joining us.

I’m going to start with you, Scott. Let’s start with the Fed. You know, we’ve got forecasts now, that call for six Fed rate cuts between now and the end of next year. Do you agree with those estimates, and I’m curious your reaction as to where you think that curve goes?

Scott Crocombe: Sure. So I’d say this I think six rate cuts projected is a lot more realistic than the 7 to 8 that we were seeing prior to the jobs number 2 or 3 weeks ago. So, I’d say we are closer to that as far as our estimates go, because that 7-8 cuts would have put us inside of 3% in terms of, you know, long term outlook for short term rates. Personally, I don’t think that’s very realistic for a fundamental reason, which I’ll get to. The second is we’re not exactly sure the economy is going to need that much help. So, we’ve taken the view that we probably wouldn’t have that aggressive of a cutting cycle. And the other one was – and this goes back to really the beginning of the year and late 2023 as well – a lot of our underwriting is focused on inflation, not surprisingly, and specifically, the inflation that matters to us, which is labor inflation. We really weren’t seeing it abate. And we had a hard time getting our arms around the fact that the Fed was going to start cutting early in the year. That’s really rolled through to now. Plus, we got the, kind of, front-loaded 50 basis point cut in September.

So, we think we’re in a place where you’ll probably get the two 25 basis point cuts through the end of the year, just because the Fed probably doesn’t want a market surprise, and I think that’d be viewed pretty negatively. After that, it wouldn’t surprise us to see a bit of a pause and, kind of, a reevaluation and maybe live somewhere inside of that aggregate six cut number. But generally speaking, if we get to the place where the Fed gets short term rates to 3-3.25% and we’re still cutting on top of that, I think we’re in a worse place than spreads and equities are implying right now. So, we’ve generally been a little bit more constructive than that.

Colbert Cannon: So, Scott, if you go down that path, regardless of the slope of the curve, that you’re going to continue to see rate cuts over the next 12 to 18 months. What’s the impact of that on your public credit business, and what should we expect with spread movements in response?

Scott Crocombe: Many of our portfolios have the ability to, kind of, freely move between loans and bonds and therefore fixed versus floating rate exposure. Much like the rest of HPS, we do full fundamental underwriting. We make every investment based upon the credit, but we obviously try to pick up excess return based upon where the convexity would live or the optionality in a certain investment based upon on a general rate view. As I said, we’ve had a view of higher for longer for some time now that has kept us overweight loans.

There was a minute there in the summer where it looked like a lot of bonds were going to going to sprint past loans in terms of performance. We’ve seen that reverse out in October, and in October alone, there’s almost a 100 basis point differential in loan versus bond performance, which is really that, kind of, resetting of people’s rate expectations. And the two indices are pretty much right on top of each other in the, kind of, mid 7% returns for the year.

For us, that means, we still favor loans. There’s a great pickup in yield. and specifically, current yield that you’re going to have to burn off with this kind of move down in the base rates. We’re fine to keep that exposure for now and earn that excess return. With bonds, we’re waiting for a little bit more convexity. So, you know, we’d like to see maybe some supply push spreads wider and get the type of opportunities that can really drive performance through dollar price appreciation. We really just haven’t seen that in the bond market much, so, we’re still favoring loans and waiting a bit on bonds.

Colbert Cannon: So, Vikas, same question for you. I mean, it’s been 15 years since we’ve seen a rate cut environment. Private credit was a very small asset class back then. Talk to us about the playbook now for your side of the house. What should we expect from that rate and therefore spread moves and how you think the impact for allocating the portfolio?

Vikas Keswani: Sure. I’d, sort of, start with this observation, which is, the vast majority of private credit is floating rate, and the vast majority of borrowers have been utilizing these floating rate loans without any hedging. And that has been interesting to watch. As you saw rates increase, that created a tremendous amount of stress for these borrowers. As we’re starting to see that turn, you’re starting to see that alleviate quite dramatically. As fundamental, underwriting focused, investors, we are measuring free cash flow – levered free cash flows – what is available, from a company’s perspective, to repay the debt that they are incurring. And what we do expect is that it will get increasingly better for the portfolio. New opportunities will obviously be underwritten with this rate dynamic in mind. but I think, where you see the real windfall is in the portfolio itself.

Colbert Cannon: Fair enough. Scott, back to you. We’ve seen meaningful spread tightening across public credit this year. Do you think at this point investors are being fairly compensated for the risks in the market?

Scott Crocombe: So, through the lens of both loans and bonds, it’s a bit of a bit of a different answer here. The bond market is extremely tight from a spread perspective. I’m not making these numbers up. Bond spreads, excluding triple CCCs for now, are anywhere between the zero and fifth percentile in terms of relevant historical norms. Obviously, that implies that we’re at or near the tights for a lot of these assets. And so, it’s led us to be very cautious of bond risk in general, specifically anything with real spread duration to it.

So, the short answer is not really in bonds. And we’re being very cautious, staying short dated. And there are some, ironically, opportunities in very low coupon paper, because, just with the way the math works, it’s still trading below par as they approach their maturity dates. Not surprisingly, companies have waited and waited and waited to refinance this paper because it’s been such a favorable coupon for them. So, dollar discounted, high quality paper where you can maybe be right on an earlier takeout versus an at maturity takeout, that’s accretive to your IRR, and we don’t think you’re introducing much to default risk or really mark-to-market risk into the portfolio. So, we don’t mind that from a spread risk perspective in bonds. Otherwise, you know, you have to move out towards CCCs to get any real spread juice into a bond portfolio. We don’t think that’s a mispricing we necessarily want to take advantage of.

Loans are a little bit different. I mean, you’re at 475 spread-wise on the loan index. That’s about the 25th percentile just to make it an apples-to-apples metric with was what I was saying about the bonds. That’s not terrible when you look at it through the context of yield, because you’re in about the 70th percentile in terms of historical yields using metric, because your base rate is so high. And like I just said, we have the view that rate might get pushed out longer, and we like that option more than the option on tightening of rates from here in the bond market. So, that’s where we’re focused most of our spread bets.

I will say, just to give you a data point on CCCs for loans too – BBs versus CCC loans are a thousand basis points apart in terms of spread. And I’m sure we’re going to talk about dispersion at some point here. But that’s a big factor in our market. And again, it’s not a segment of the market we want to be playing in, from a risk perspective. And so, we’ve stayed away from that.

Colbert Cannon: Vikas, on the credit side, private credit often gets painted with a very monolithic brush. And of course, that’s not right. There are a bunch of different, sort of, lanes within it. We’ve seen greater spread tightening in, sort of, more flow private credit, and less spread tightening in more complicated, nuanced stuff. Can you talk through a little bit about those dynamics and where you see the opportunities?

Vikas Keswani: As you know, Colbert our industry is primarily made up of folks that are lending to private equity firms. And, when you drill down a little bit further, what you notice is people are really focused on LBOs, leveraged buyout lending. This is, sort of, your traditional situation in which a buyer is purchasing a business for, let’s say, $100 and seeking $40 to $50 of financing. It tends to be quite competitive. Why? It’s relatively easy to get into. You call up all of your friendly private equity firms, and you say, hey, let us finance your deals. The underwriting, for the most part, is, in the purview of that financial sponsor, of that private equity firm. They do a lot of good work, and you can benefit from it. And so, we do take the view that market is the most competitive.

There’s also a little bit of a lack of M&A going on in that market, causing an even further tightness in spreads. But if you go beyond it and are willing to do the work, really not relying on that private equity firm but relying on your own underwriting, your own capabilities, prosecuting due diligence yourself, you can start lending to companies outside of the LBO space, which would be private equity firms as well, but those seeking a refinancing, a token acquisition of some sort, or further afield, non-sponsors or public companies, private companies, companies owned by sovereign wealth funds, other types of institutional investors. We’ve seen less spread tightening there and less competitive tension there generally.

Colbert Cannon: Yeah. It makes sense. Scott, I want to pick up on a thread you left off on around dispersion. You know, that’s been a real theme in the credit markets the last couple of years. Do you expect that to continue, or do you think you’re going to see more performance compression going forward?

Scott Crocombe: So, just on what we’ve seen so far, because I think it is informative to where we’re going, we’ve seen dispersion get a lot worse in the same time period that we’ve seen the credit markets and spreads get a lot better, meaning tighter markets, more dispersion. Obviously, that means it’s taken to an utmost extreme in terms of this metric that we’re that we’re focused on here. So, one of the big reasons for that – and Colbert, you deal a lot in situations like this, I know – is that downgrade risk and certainly the need to raise liquidity has really been punished in this market environment. And we actually think for good reason because, a lot of times now, default risk or even the potential for default has become much more of a foregone conclusion because the market is so, I won’t say over-manipulated but manipulated by folks who want to intervene proactively, be that the advisor community is obviously pursuing transactions, private lenders who are seeking to do creative deals and interesting financings to help companies alleviate defaults. But as we know, with documentation and liability management these days, that can take on, a form that is actually to the detriment of the existing lenders in a capital structure, even though it does avoid a potential default.

So again, we’ve really focused our research team on trying to underwrite to, not only performing scenarios in, say, a base and a stress case, but also to avoiding downgrade risk and the need for incremental liquidity in both of those cases as well. So, I don’t think dispersion is really going to abate very much. I think it’s, kind of, here to stay, and we’ve hit a bit of a new paradigm in terms of what it means for our market now.

Colbert Cannon: I’m going to go back to you, Vikas. You know, we’ve been in a higher rate environment now for 18 months or so. The reason for that, obviously, was we saw inflation – inflation, as Scott said, has remained endemic. How is the portfolio holding up against that environment of higher costs, higher borrowing costs? How’s it doing generally?

Vikas Keswani: Surprisingly well. I mean, if you look at the few years since Covid, we’ve had one-off events to talk about, and we can talk about freight increasing quite dramatically given various port closures, shipment volumes, Red Sea issues, so on and so forth. We’ve seen inflation, as we’ve already talked a lot about, but particularly in commodities, very specifically with crude as well as raw materials. And then we’ve seen wage inflation, and that will hit very specific sectors, be it health care, retail, consumer-oriented sectors, that sort of thing. Each of those issues, though, have been relatively sporadic in terms of intensity.

Colbert Cannon: Episodic.

Vikas Keswani: There’s a better word. I do think – and I wanted to connect the comment to what Scott was talking around dispersion – I do think, in private credit, dispersion is going to come from ultimate losses and how one manages to stress.

Colbert Cannon: Scott, same question for you. How’s the portfolio holding up against this rate and inflationary environment?

Scott Crocombe: There are a lot of pitfalls in this market, and it’s more about what you don’t do than what you what you accomplish, if you will, from your underwriting. So, what you avoid and what you’re able to move out of is equally, if not more important than, kind of, the wins you have, especially when, what we’re trying to capture are historically attractive yields plus some upside there. That’s what we’re underwriting to.

And so, we have, I think, experienced some stress early on in the portfolio. Vikas hit on a few of them. You know, physician-oriented and patient-oriented health care, where there’s a skilled labor component, we’ve seen margins pretty much evaporate, certainly at a given point in time in that industry. Anything tied to logistics or some sort of cyclical swing that would require an inventory destocking – these are things that we thankfully front-loaded a lot of work on, identified some issues, and moved on from a few situations. So, that’s been a big part of our strategy in terms of how to keep the level of performance within the portfolio.

Colbert Cannon: Vikas, you mentioned M&A volumes. And obviously, we saw a real chilling effect in M&A because of the rates move. If you look at the private credit side of the house, you know, historically we do about two thirds M&A related, about one third refinancings. That’s been inverted for the last year or so. Do you see signs of M&A volumes picking back up, and if so, what do you think drives that resumption of activity?

Vikas Keswani: I’m going to make a little bit of a nuanced point here, which is, you’re right to say M&A volumes, in terms of actual transactions, is depressed – 70+% in the market that we would be ordinarily targeting. However, I do think M&A activity has been quite elevated. And what I mean by that is, if you talk to investment bankers and owners of assets and buyers of assets, assets have been marketed quite heavily, in fact. They’re just not transacted. And there’s this significant, maybe, compressing disconnect between buyer and seller on price, on valuation. So, it’s not for lack of effort or lack of trying that you haven’t seen M&A volumes.  If I were to guess, and I’m speculating here, I would say there’s probably a 15%, maybe 20% gap between buyer and seller. And so, how do you achieve the gap?

Well, one way to do it is, as a seller, you just accept a lower price. The issue here is a lot of private equity firms have marked their portfolios at very significant levels, so taking that mark-down and realizing a lower price below that mark – it’s a challenge. You’ve been telling your investors what the asset is worth, and you can’t achieve that valuation. That’s very challenging, frustrating, and so forth.

One way, to solve this problem is to have the portfolio company grow into that valuation, and I do think a lot of private equity firms have been waiting for that. Some will actually achieve that growth and be able to transact, and we expect that to kick up activity. However, many will not. And so, I don’t actually think and don’t expect that M&A volume will rebound entirely, overnight, but I do think we’re at very depressed and low levels, and you will start to see significantly more activity than we have, recently.

Colbert Cannon: So, the benefit of time plus, obviously, the rate cut, making that bid-ask valuation spread not quite as problematic.

When we’re talking about trends, Vikas, the other thing that we’ve seen is these private credit deals continue to get larger and larger.

Vikas Keswani: Yes.

Colbert Cannon: There are deals getting done in the multibillions that, five years ago, you couldn’t have said that. Not even two years ago could you have said that with a straight face. Do you expect that to continue?

Vikas Keswani: Yeah. Absolutely. One of my favorite charts to look at is the S&P Leveraged Loan Index and the price action. If you look at it over the last 20+ years, what I find and I think you would find astounding is the volatility. You know, we’re talking about very large companies and the loans, not the equity, of those businesses, and the amount of volatility that has existed is really a function of the change in the banking system.

Post 2008, 2009, you’ve got banks being forced to hold less assets, given regulation. And as a result of that, you create more market volatility where these loans get executed and traded, without the banks there to hold them as a buffer.And so, when you boil it all down, I think borrowers are sitting there and saying, “We will pay more for private credit, but it is certain, it is quick, and I know my lender. I don’t have to talk to 50+ lenders to get something done. I can call up one or two or a few.”

And I think that will continue to grow the market. We’re at $1.7 trillion in size now, compounding at 10-15+% a year. I think that continues, and the capital is there and available for it. So, I do expect it to continue.

Colbert Cannon: One last theme on private credit. You’ve seen an increasing number of deals in the private credit market employ PIK interest at least for some portion of their spread in the current environment. Talk to me a little bit about the drivers behind that and whether you expect that to continue in the coming years.

Vikas Keswani: Yeah. This is a really interesting topic and very timely. I think there is really two versions of PIK, where one is quite acceptable and the other somewhat worrying. And I’ll walk through both.

In terms of the acceptable version, yes, you’re right, with the rates as high as they are, if a company needs some flexibility, whether it’s for a short period of time to operate and actually invest in their business, you may offer some PIK flexibility. It is something the public markets don’t do or don’t do well, I should say, and as a result, borrowers do value it in the private markets and make use of it. And it is very constructive in allowing for a borrower to pursue their business plan, whatever it may be. We do that. We do it on occasion. We’ll PIK a very small portion of the spread, and we’ll keep the time horizon quite limited, let’s say 12-18 months, and we’ll also charge a premium for it. That version of PIK, we think, is a very attractive way to win transactions and quite helpful to grow the portfolio with very nice, high-quality assets.

Colbert Cannon: And before we move on from that, we always say, you have to earn your right to have PIK interest, and these are earned scenarios where it actually is deserved, and it makes sense for both sides.

Vikas Keswani: You said it well.

Colbert Cannon: Where’s the problem?

Vikas Keswani: The problem is the inverse, which is, you didn’t underwrite that loan to have PIK. You experience some stress down the line in three or four years, or you’re near maturity, and there is a problem refinancing your loan. So, you offer the borrower PIK. Growing up in credit, I always thought, if you can’t pay interest or you can’t pay principal at maturity, that’s a default. If you take this concept to the extreme and you PIK all interest and push out maturities, you know, you may never have to report a default.

Colbert Cannon: You and I are dating ourselves that I’m nodding vigorously at this.

Vikas Keswani: You more than me (laughing), but this is a real issue. And if you see some of the press around portfolios having an increasing number of fully PIK’d assets, what they’re really doing is hiding defaults.

Colbert Cannon: Yeah. I had an investor meeting this morning, and somebody asked me a question about percentage of PIK in the portfolio. And I made the same point. You need to say: it’s not what the percentage is PIK. It’s how many started there. Ending up there is a very different set of circumstances. That makes total sense.

Scott, I want to talk a little bit about the overall health and the trade-off between the public and private markets. They’re not always directly competitive, though, as Vikas said. You know, if you’ve got time, and it’s an easier story, of course it’s a better execution. What are you seeing in terms of the pass back and forth between public and private? There were points 18 months ago where private deals were taking every public deal normal execution because the markets were closed. That’s obviously changed greatly in the last year. What are you seeing in terms of the public versus private execution?

Scott Crocombe: Yeah. I think coming off of that period of time where it was clear that, for the public markets, it was a struggle to get things done for obvious reasons, as Vikas mentioned. We go to heavily correlated moves in price and a lot of volatility pretty quickly, and that can really be tough for borrowers. And it’s great that private credit is there as another option. I would say, coming off of that, with the, kind of, rebound in the markets obviously, syndicated lenders are feeling better about the world. I’d say we’ve reached a better state of equilibrium.

And look, at HPS, we have the benefit, without having a restrictive wall, of understanding a loan that might live in a contemplated private world for a minute and then ultimately end up in the in the syndicated markets. We, kind of, get to see that life cycle, and it’s becoming pretty quick. The decision amongst borrowers, they’re getting very, I’d say, efficient and sophisticated in terms of recognizing where the value is for them and pivoting back and forth. But that’s not to say they’re necessarily playing one off the other to the detriment of one of the markets. I think private credit is doing the right thing in the sense that it is providing a very viable option and not egregiously expensive. There is obviously a premium on a private credit deal, but if a borrower wants to pivot, we’re seeing that happen over the course of, let’s say, weeks or maybe a month, a month and a half, probably more than we would definitely in the environment you were referencing.

And so, I think the markets are, essentially, helping borrowers price risk, which I don’t think is unhealthy for any market. Any time there are checkpoints and ways for everyone to understand where risk is going to be clear, and it does so efficiently relative to the desire of both the buyer and seller, I think we’re on a pretty healthy place right now.

Colbert Cannon: And Vikas, from your side of the house, as Scott correctly pointed out, we’re at historic tights on the public side. What impact does that have on the private credit side of it?

Vikas Keswani: When you have frothy and well performing public markets, you should expect to see less volume on the on the private side. I do think, though, you still have this idea that private credit provides speed and certainty in rapidly changing environments.

We have geopolitical issues around the world. We have trade issues, strikes, port implications, so on and so forth. So, there’s a lot to worry about. And I think borrowers, despite a very healthy public market, still value that alternative. And I think that is a way to describe the market is balanced.

Colbert Cannon: Well, I might add to that, you know, a clean and simple story that, in a 45-minute meeting, you can explain why it’s a good credit, that always will favor a public execution. You input any kind of complexity – it’s a corporate carve out, it’s emerged as something that requires more work, even in a robust environment – the private markets can often prevail.

Well, let’s move then to the last set of thoughts here. Scott, I want to move back to you. You know, let’s put our crystal ball hat on for a second. Given the environment we’re in, given some of the puts and takes that you guys have addressed, are there themes or subsectors when you look at 2025 and beyond that gets you excited for the public credit sector?

Scott Crocombe: Sure. First on a market theme, personally, I love underwriting bond risks, where you can buy high-quality credit with some convexity that can move prices higher, because I think that’s generally misunderstood by the investing community – fixed price convexity in the credit markets.

Colbert Cannon: We have 15 years of zero interest rates, so nobody got to see any of that.

Scott Crocombe: You can have BBB borrowers whose bonds trade at 120 cents on the dollar, and you can get real double digit returns if you’re able to, kind of, identify the right time period and opportunity set. You know, everybody talks about maturity walls and the like. If you look at 2025 and 2026, the one thing that sticks out to us is that there’s about $200 billion of bond maturities coming, you know, in those two-year categories. And like I said earlier, CFOs and Treasurers have been very, very reluctant to proactively refinance because their stated coupons have been so low for so long. So, we’ve got about 10% or 11% of the market maturing in those two years. Historical norms are something more like 6-7%. So, that’s a bit of a bubble in terms of what needs to come to market.

Inherently, these are higher quality issuers because, if you go back to when these bonds were issued, it would have been during Covid, and who had access to the unsecured markets during Covid? It was only the, companies that historically could access the debt and equity markets and had the ability to sustain tough economic environments. And so, we think there is – I won’t say a swell, but at least – an increasing flow of high-quality credit that’s going to come to the market with some duration and price convexity to the upside. So, we think bonds will have their moment sometime in 2025 or 2026, and we want to be ready for that. So, that’s a big market theme that we’re focused on.

As far as our portfolios and our borrowers, we try to stay close to a lot of, kind of, tenets from an underwriting perspective, which are, we avoid a lot of cyclicality. We avoid a lot of commodity risk. We like leverage cash flow models – service industries, brokerage and financial services, business services, health care, technology, things like that. And then, obviously, software is a huge component of our market.

And so, what we’ve really tried to identify is on the solution and, kind of, product level – AI, things like that. Who’s integrating that the best? Who stands to be a winner versus somebody who’s displaced? And look, I think much like HPS across the board, we want to focus on our underwriting and always try to outperform on credit selection. We’ll get some market moves right, but if we outperform on credit selection, we think we’re going to be okay, and that’s what we’re working on.

Colbert Cannon: All right. Vikas, the same for you. What are themes or sectors you get excited about?

Vikas Keswani: I’ll add on to what Scott identified. I think AI is something we’re all talking about. The infrastructure that’s required to get AI to where it’s headed is something to think about. It will be disruptive for a number of industries. It will be productive for a number of industries. We think about that. There’s, sort of, less obvious, sectoral shifts, one being GLP-1 drugs – how they’re impacting consumption, retail, and rapidly changing consumer preferences.

Putting it all together, though, one thing I would highlight as to how we think about portfolio construction in a very unique way, we like sector diversification. You know, when you look at private credit writ large, a lot of our peers, because they’re very focused on LBO lending very specifically, have no choice but to be overweight software and health care. You see a lot of portfolios with 30-50% allocated to software and 20-30% health care. That’s pretty standard in private credit land. We’ve taken a very different approach and decided that, while I can share some thoughts on AI and GLP-1 drugs and other sectoral perspectives, the better approach, from a pure credit perspective, is sectoral diversification. Keep it extremely diverse. It’s really a lesson we learned from Covid and are implementing pretty regularly.

Colbert Cannon: Makes total sense. All right. Well, listen, thank you, Scott and Vikas for being with us today. We appreciate your insights. For those listening, thank you for listening. And, don’t hesitate to reach out if you have any questions. Have a great day.