A noisy yet resilient year for US private credit

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SIMON BROWN: I’m chatting now with Harris Gorre of Grovepoint Investment Management. They of course run the local AMC [Actively Managed Certificate] on the US private credit market.

Harris, appreciate the time. A noisy but ultimately solid year for middle-market direct lending. I want to start off with Liberation Day – and when I say ‘noisy’, I’m probably underselling it. But we chatted earlier in the year and you commented back then that really Liberation Day was a pricing event, not a credit event. It was scary, but there weren’t defaults.

HARRIS GORRE: Simon, I think that sums it up pretty well. There’s been a lot of noise this year, and Liberation certainly got us off to a volatile start in April. Frankly, I think the expectation, even from our side, was that there would be more kind of credit knock-on events than were actually realised over the remainder of the year. And in fact what we’re seeing now is an improving kind of credit cycle.

But we kind of thought tariffs would have more of an impact than they have had. I think the whole market kind of thought tariffs would have more of an impact.

What we saw in reality was that especially the US middle market was very, very resilient in the face of tariffs.

There were a few subsectors that were impacted, mainly companies that were heavily reliant on Chinese imports – in the toy sector, say, and some of the beauty and cosmetics. But these were very, very, very small parts of portfolios, if at all. So the ripple effect through the middle market just wasn’t realised.

And looking at it a bit more carefully over the year, we kind of know why. When you look at those middle market companies, they produce, they manufacture and they distribute in the US. When you took a look at their kind of cost of goods sold you saw almost less than 4% of their cost of goods sold were imported. So tariffs really did have very little impact. And from a Trump point of view, it probably wasn’t the worst policy to in fact look to support those companies.

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SIMON BROWN: So kind of getting some benefit from it, and mid-market, which is where the private credit predominantly goes. So tariffs actually are maybe just a benefit more than an issue.

They’re continuing to grow revenue. They’re continuing to grow profits. And at the same time the rates for their private creditors has actually been coming down. They’re probably sitting in a better position than they were a year ago, perhaps.

HARRIS GORRE: We’ve certainly seen the credit cycle peak, from what the numbers are telling us. So if you if you cast your mind back to, say, just over a year ago, September 2024, you had Sofr [Secured Overnight Financing Rate], or the overnight call it risk-free rate or the Fed rate, whatever you want to label it as, sitting at around 5.5%. Today we’re sitting at 4%.

So you’ve had a 150-basis-point cut in Fed fund rates. And these are really floating rate loans. The market is the floating rate market.

So any borrower that had a decent business model but was running against kind of tight cash flows because of the sharp interest-rate increases, has had a lot of relief over the last 12 months. And we’ve seen that play through the numbers.

So you’ve had on one end earnings growth, Ebitda [earnings before interest, taxes, depreciation, and amortisation] growth and on the other end essentially your debts become cheaper. So we saw probably the peak in defaults in Q1, Q2 this year, and since then the numbers have just improved. Interest coverage ratios, not accruals are inside of kind of 10-year averages.

So once again, speaking to how you started, it’s been noisy but the underlying fundamentals have been really solid and improving.

SIMON BROWN: And there have been some blow ups in the broader credit space, but not in the space that you’re operating, not in those private credit spaces, as I understand. And I appreciate every blow up – every headline loves them. But it hasn’t been happening in this space from a fund perspective as I see it.

HARRIS GORRE: Yes, I think from a social media or print point of view it doesn’t pay to write about ‘everything’s normal and if anything, slightly improving’. Tricolor and First Brands for us were very idiosyncratic blow ups. Those were more recent blow ups. The only thing that made those two kind of companies private credit in nature was the fact that they were unlisted companies. Their debt was actually structured by banks, issued as syndicated loans or held in ABS [Asset Backed Securities] vehicles, CLO [Collateralised Loan Obligation] vehicles.

These are all kind of banking-engineered debt stacks, so we had no exposure across any of our portfolio to either Tricolor or First Brands…

Actually, Simon, when you look at the broader universe where we see about 130, say, listed vehicles out there that you could invest in, we probably look at 45 of those and say those are high-quality vehicles that we would invest in. And then you would narrow that down to us holding 15 to 25 of those vehicles at any one time.

Across our broader universe of, say, 45 investable, none of them had any exposure to those two names. So these weren’t direct-lending names. They weren’t names that fit into direct-lending portfolios. They were kind of more esoteric type credits.

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SIMON BROWN: Absolutely. And as we sit now – and I’ve chatted about this before – these are funds you are buying. They trade. They sometimes get volatile. They trade at premium to Nav and sometimes they trade at a discount to Nav. You make the point that you’re seeing that discount to Nav there, which gives you an almost immediate uplift, almost getting sort of equity-like potential returns from what is sort of really secured cash-flow lending.

HARRIS GORRE: So when we look back, we’ve seen a few of these instances over the last 10 or 15 years. The last one was kind of September ’22, where we saw a big sell off in the market. It was when rates started going up and everyone panicked and thought there was going to be a big kind of default cycle on the back of the Fed increasing rates as sharply as they did.

The default cycle didn’t materialise, but the entry point at that point was very attractive. Post that we saw the strategy we run had generated 20% in 2023 and I think 11% last year, and that was from this kind of discounted entry point.

And we’ve seen that happen again with the recent headlines, the selloff in the market. Once again there had been fears about a default cycle.

We were kind of seeing the fundamentals moving the other way. But prices in the listed market a few weeks ago were trading at 0.8 of book value. What that effectively means is that you’re buying a low in that market 100.

So if you’re in one of these evergreen vehicles or semi-liquid vehicles or in a private credit fund, that loan remains marked at 100 and you’re buying it in the listed market at 80 cents on the dollar. That does two things. One, it juices up your returns when things normalise. And/or if things don’t normalise and the listed kind of retail market is actually correct, which is not where we think it is at the moment, you’re protecting your downside because you’re already buying that loan at a discount to book value. So you’re essentially kind of covering yourself for that first 20 cents of losses.

And what we’ve seen among the high-quality lenders is when these loans do go bad they tend to recover a lot of their kind of value. So you really are getting a far more attractive trade buying into the listed market at these levels, both on the downside and the upside.

SIMON BROWN: And the upside. And you’re [saying that] you don’t go and buy a single loan. There are thousands of loans packaged in these.

HARRIS GORRE: Another advantage of trading on the Nasdaq in New York Stock Exchange-listed vehicles is that each vehicle has anything from 70 to 500 loans, depending on the manager and how large the vehicle is. In our current portfolio, I think we have 3 580 loans, or 3 580 borrowers. We’ve touched on this a few times over the years – that when you’re investing in credit, if you can get to a certain quality of credit, you want high quality credits in your secured lending, good lenders, guys who can get in there and work out loans that go bad; and then you want as much diversification as possible because your yields are always going to be that 10%, 11%.

That’s kind of where that private credit market trades. You’re not going to get paid 15% suddenly because the company is doing well.

So you don’t want to call it alpha you get from an equity fund where you want a manager to put their neck on the line and concentrate their positions. In this type of strategy, you really want as much diversification as you can get while staying away from cyclical sectors and kind of more volatile performers and more esoteric names like the ones we’ve seen more recently in the headlines.

SIMON BROWN: We’ll leave it there. Harris, I appreciate the time.