2024 Direct Lending Outlook

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This is a podcast episode titled, 2024 Direct Lending Outlook. The summary for this episode is: <p>Can the impressive growth of the direct lending asset class continue? Or will higher rates and increased competition mean more defaults and lower spreads are on the horizon? Our experts across the U.S., Europe and Asia-Pac weigh in on the prospects for the asset class in 2024.</p><p><br></p><p><strong>Moderator:</strong></p><p>Natasha Sahi, Client Portfolio Manager - Global Private Finance</p><p><br></p><p><strong>Panelists:</strong></p><p>Tyler Gately, Head of Client Portfolio Management - Global Private Finance</p><p>Justin Hooley, MD, APAC Region - Global Private Finance</p><p>Adam Wheeler, Co-Head of Global Private Finance</p><p><br></p><p><strong>Episode Segments:</strong></p><p>(04:29) - How private credit is positioned against an uncertain macro backdrop</p><p>(11:17) - Assessing the overall health of the middle market</p><p>(16:37) - Default expectations for 2024</p><p>(19:08) - How the competitive environment differs by region</p><p>(23:22) - Are we seeing the beginning of manager dispersion?</p><p>(27:13) - How LP's can diligence the quality of managers' origination</p><p>(29:48) - Bull and bear cases for 2024</p><p>(32:53) - How to think about private credit allocations in 2024</p><p>(36:49) - Bold predictions for the year ahead</p><p><br></p><p>Certain statements about Barings LLC made by the participants herein may be deemed to be “testimonials” or “endorsements” as those terms are defined in rule 206(4)-1 under the Investment Advisers Act of 1940, as amended. Participants were not compensated in connection with their participation in this program, although in certain cases they are investors in Barings LLC sponsored vehicles. These investments subject such participants to potential conflicts of interest in making the statements herein.</p><p><br></p><p>IMPORTANT INFORMATION</p><p><br></p><p>Any forecasts in this podcast are based upon Barings’ opinion of the market at the date of preparation and are subject to change without notice, dependent upon many factors. Any prediction, projection or forecast is not necessarily indicative of the future or likely performance. Investment involves risk. The value of any investments and any income generated may go down as well as up and is not guaranteed. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Any examples set forth in this podcast are provided for illustrative purposes only and are not indicative of any future investment results or investments. The composition, size of, and risks associated with an investment may differ substantially from any examples set forth in this podcast. No representation is made that an investment will be profitable or will not incur losses. </p><p><br></p><p>Barings is the brand name for the worldwide asset management and associated businesses of Barings LLC and its global affiliates. Barings Securities LLC, Barings (U.K.) Limited, Barings Global Advisers Limited, Barings Australia Pty Ltd, Barings Japan Limited, Barings Real Estate Advisers Europe Finance LLP, BREAE AIFM LLP, Baring Asset Management Limited, Baring International Investment Limited, Baring Fund Managers Limited, Baring International Fund Managers (Ireland) Limited, Baring Asset Management (Asia) Limited, Baring SICE (Taiwan) Limited, Baring Asset Management Switzerland Sarl, and Baring Asset Management Korea Limited each are affiliated financial service companies owned by Barings LLC (each, individually, an “Affiliate”).</p><p><br></p><p>NO OFFER: The podcast is for informational purposes only and is not an offer or solicitation for the purchase or sale of any financial instrument or service in any jurisdiction. The material herein was prepared without any consideration of the investment objectives, financial situation or particular needs of anyone who may receive it. This podcast is not, and must not be treated as, investment advice, an investment recommendation, investment research, or a recommendation about the suitability or appropriateness of any security, commodity, investment, or particular investment strategy.</p><p><br></p><p>Unless otherwise mentioned, the views contained in this podcast are those of Barings and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. Parts of this podcast may be based on information received from sources we believe to be reliable. Although every effort is taken to ensure that the information contained in this podcast is accurate, Barings makes no representation or warranty, express or implied, regarding the accuracy, completeness or adequacy of the information</p><p><br></p><p>Any service, security, investment or product outlined in this podcast may not be suitable for a prospective investor or available in their jurisdiction.</p><p><br></p><p>Copyright in this podcast is owned by Barings. Information in this podcast may be used for your own personal use, but may not be altered, reproduced or distributed without Barings’ consent.</p><p><br></p><p>23-3260930</p>

Speaker 1: The direct lending market continued its almost meteoric rise in 2023, becoming by some estimates a$ 1. 5 trillion market and increasingly a core allocation for institutional investors. Can this impressive growth continue or will higher rates and increased competition mean more defaults and lower spreads are on the horizon? Welcome to the Barings 2024 Direct Lending Outlook where our experts across the US, Europe, and Asia- Pacific will weigh in on the prospects for the asset class in the year ahead. This episode is part of our 2024 Outlook series, which in addition to this episodes includes conversations on public fixed income and global real estate. You can follow along on our Streaming Income podcast feed, our YouTube channel or by visiting barings. com where we are posting audio, video, and written versions of these conversations. With that, here is Barings's Natasha Sahi to kick off the discussion.

Natasha Sahi: Well, welcome everyone. So great to host so many of you today for this discussion. My name is Natasha Sahi. I'm part of the private finance group here at Barings, and I'm delighted to be joined by my colleagues today for this discussion. As you know, the theme of our 2024 sessions is really coming into focus as we sit today amidst of backdrop of heightened risks, geopolitical, macro, inflationary. I think the outlook for 2024 can sometimes feel quite blurred. What we wanted to do today with our direct lending team is to really focus on the outlook for 2024 and dive into some of the issues that we're all worried and concerned about and bring them into focus for you, so delighted to have you join us today. Without further ado, maybe I'll pass it over to my colleagues to give their introductions and to get us started. Adam, why don't you kick us off?

Adam Wheeler: Thank you. Thanks for joining us today. My name's Adam Wheeler. I co- head our platform here at Barings, our private finance platform. For my sins, I am on our US, European, and Asia- Pac Investment Committee, so hopefully I can give you some perspective on what we do in our platform today.

Natasha Sahi: Thank you. Justin?

Justin Hooley: Hey. Thanks, Natasha. My name's Justin Hooley. I've been at Barings two years and I am an MD in the Sydney private finance team and I run the effectively APAC investments from there.

Natasha Sahi: Tyler?

Tyler Gately: My name's Tyler Gately. I'm a managing director in the private finance group as well. I lead our client portfolio management efforts.

Natasha Sahi: Thank you all. Maybe a lighthearted question to kick us off and stimulate some discussion. For our audience, what is the best book or podcast that you have read or listened to this year and why? I can see you're all itching to answer this question, so, Tyler, why don't you kick us off?

Tyler Gately: I think we'll probably talk a lot about headwinds and concerns so I'll keep it lighthearted. Not going to comment on the quality of the music, but I'll say Taylor Swift biography, reading with my two little girls.

Adam Wheeler: Cool.

Natasha Sahi: Some surprises there.

Tyler Gately: Yeah. Yeah, yeah, yeah. Yeah. Justin, what about you?

Justin Hooley: Natasha, following the theme, and I think it's just coincidental, but I read a book called Stolen Focus, which is by a guy called Johann Hari and it's all about how we all get distracted these days with having six or seven devices that are all buzzing or jumping around on the table or distracting us from trying to get on with concentrating on a task for a period of time.

Adam Wheeler: Yeah, you love these questions. I had a sensible answer and then a truthful answer. I think the sensible answer is The Australian newspaper actually has a really good podcast where it does some investigative reporting that goes over several weeks and there's been a bunch of stuff on there that's been good, but the real answer is I just read too many magazines on wine and look into that too much, as these guys probably know. inaudible.

Natasha Sahi: Yeah. That's that's where the knowledge comes from. Understood.

Adam Wheeler: Yes.

Natasha Sahi: Well, thank you for sharing. If we have any audience members that have questions on Taylor Swift or wine or staying focused, we know who to go. Maybe taking a step back, if we could set the scene and just talk about the overall backdrop for private credit markets today. We get a lot of questions from our investor base around the challenges of investing in a high interest rate environment, the inflationary backdrop, geopolitical risk, all of those sorts of headwinds. Tyler, maybe you could kick us off and just set the scene a little bit. How is the asset class more generally positioned in this environment?

Tyler Gately: I think some of the nuances to the asset class that I think we oftentimes take for granted is the direct nature of the loans that we're entering into. We have continuous dialogue with the management teams, we have great access to information and have the ability to get out in front of situations far more easily than our liquid market counterparts. Beyond that, also structurally when you think about the vast majority of the transactions in our market are covenanted deals, that gives us another lever to pull to get out in front of potential issues. But then finally, I think one thing to keep in mind is private credit market generally speaking avoids a lot of the more acute underperforming industries. We generally are not investing in commodity spaces, and those tend to be the industries and the sectors that lead underperformance in down cycles and obviously outperformance in up cycles, but that dynamic limits the volatility in the space and I think because of that we'll generally be okay. That's not to say we're going to be immune.

Adam Wheeler: Yeah. I think a couple of those points are worth building on. I think Tyler touched on it. I think it's around... Well, generally if you look at the asset class, it's actually performed really well over the last decade and all investors always say that's through a period of time where we've had a pretty benign economic backdrop, but I think a lot of it boils down to around asset selection, the fact that you're sourcing, originating your own assets so you're very focused on picking the assets in industries that you want exposure to. I think that's very different to what you see in a public markets allocation where generally if you're in a public market, you're in and around an index which is across all industries. I think when you look across direct lending portfolios, they all have a bent to the defensive industries that Tyler referred to, and I think the industry as a whole has benefited from that tilt. You're generally exposed to less cyclical sectors in the space.

Natasha Sahi: Yeah. Justin, from your perspective, APAC?

Justin Hooley: Yeah, look, I think the sectors we focus on are no different to what we're doing globally. I think it's those defensive sectors. A lot of our companies in the healthcare space or education or mature recurring revenue tech technology companies, so stuff that's very sticky, very stable, very high cashflow conversion. I think ultimately probably the bigger difference we do see in APAC versus the US or Europe is that the companies we're lending to are typically number one or number two in their fields and they've got dominant market share. We do call Australia sort of the land of geopolies and it's very hard for other people to get scale, other competing companies, and so that really protects us and even a company that only has EBITDA of, say, 15 or 20 million will be a market leader in its niche, and that is really important when it comes to... Especially we've seen over the last year where there's been very high inflation, but these companies have been able to pass through price increases to the end consumer because of their market position.

Natasha Sahi: Do you think it's also fair to say that the asset class is also I guess better capitalized than it was in the GFC? If you think of the ownership structure, there were a lot of banks in the space. You think of the ownership structure today, it's much more institutional, particularly in North America, which I think is going to give the asset class a lot more stability as well.

Adam Wheeler: I think that's a really-

Tyler Gately: inaudible.

Adam Wheeler: Sorry.

Tyler Gately: No, I think that's a huge part of it. I think when you look at the experience of the GFC and what we see today, the GFC was predominantly a liquidity crisis. There was no liquidity in the market. We do not have that situation today. That's not to say we're not going to have economic headwinds and challenges that we're going to have to deal with, but I think it's going to be fundamentally different.

Natasha Sahi: Yeah.

Adam Wheeler: Yeah. I think your observation is an interesting one because I'm old, I've been around doing this for a while, so when we were doing transactions back before the GFC, and admittedly in Europe and AIPAC that was a banking market, a leveraged finance market, in the US there was definitely a developing direct lending market, but when you looked at structures back then they were definitely structured to perfection, if you like. You would have a first lien, a second lien, maybe a piece of inaudible and then a very thin piece of equity. Cash flows were very, very tight, and when things went slightly off course then basically businesses or transactions would pop at that point. I think what you see now in... Particularly in direct lending you see significantly more simpler structures, either a piece of unitranche debt or a first and second lien piece of debt, but the big difference I think is just the amount of equity in transactions. It was not uncommon back then to see 20, 25% equity sitting underneath you. Now it's definitely... I mean, today we're seeing more like 55, 60% equity sitting underneath us. Now you can argue enterprise values are massively inflated compared to where they were, but I don't think enterprise values are going to go back for a performing business to where they... Down into the mid- single digits for a solidly performing business. I think that equity cushion sitting behind us now is significantly more than it used to be.

Justin Hooley: I think the other part to pick up on is the vast majority of the companies we back have a private equity sponsor involved, so I'd say it's probably over 90, 95% of the book. We really like private equity sponsors. Why? Because they bring a lot of the diligence going into the business. We're looking at a business at the moment and they've got a full suite of almost... They're ex- executives of this business which they're looking to buy, which provides them a lot of insight of what it's really like. They really get under the hood. We do that. I think Tyler sort of alluded to that. We have access, we're really at the front end, and we can dive into that, so they bring that discipline, they bring good corporate governance discipline, and then they have the pockets so if companies do get into trouble and face speed humps, they can put more money in if required or throw resource at it to try and sort out the thing. I think it's a good asset class from that perspective where you've got a good captain of the ship, if you like, to try and push that through.

Natasha Sahi: Maybe kind of taking that backdrop and segueing to the overall health of the middle market, I mean. For those of our investor base that are dialing in, they'll know that we have a very specific focus, to your point, Justin, on private equity- backed companies focusing on the core middle market. When you think of the rising rate dynamic, that's a double- edged sword I think for our asset class. Obviously being floating rate in nature, it's great we can deliver a higher return to our investors but that's also a higher interest burden that these companies have to bear. How are they, generally, speaking across your regions holding up? Maybe Adam turning to you first for your perspective from Europe and maybe just the bigger picture across the portfolio.

Adam Wheeler: Yeah, sure. I mean, maybe to take a step back I think it's worth just looking at the overall performance of businesses and how they held up over the last 18 months, 24 months, and then overlay that with how much cash have they got to pay interest today in a much higher base rate environment. I think, look, we've seen some common themes I think across the US portfolio, European and Asia- Pac businesses. I think you've seen... Over the last 18 months, you've definitely seen initially I think, particularly when Ukraine situation occurred, supply chain issues, particularly higher energy costs. I think we've seen energy costs abate over the last 12 months, but the biggest impact I think has just been inflation, particularly on wage inflation. We've probably seen higher wage inflation here in Europe than we have in the US, but we have seen businesses respond to that generally through trying to push through price increases, which to be honest has surprised me because you've seen that that suggests demand has been quite robust over the last 18 months or so and companies have continued to push price increases through to maintain performance. That's positive, but then when you overlay that with having to pay an extra 500 basis points of interest expense on top of what you were paying before, I know we're going to get to where do we think it's going to go, but I think you're definitely seeing cash flow getting tighter in businesses just as a consequence of that, even where companies have been performing okay. I think when you look across the portfolio, it has surprised me how well things have held up given just the increase in base rates and the economic backdrop that companies have experienced.

Natasha Sahi: Tyler, Justin, some perspective from your regions?

Justin Hooley: I think, look, I think as a firm we've done a lot of analysis on the underlying stats in the portfolio, and I think that's thrown up some interesting observations from our side and the APAC thing of EBITDA margins have held relatively constant. Interest cover, which is a key metric that we focus on going into deals as well as as we track through, has come down, has got tighter, and invariably it's going to. When interest rate goes up 400 basis points, you're not going to get around that, but the interest cover at least for the APAC book is still strong and still in a good place. I think it probably comes back to, again, what we've said is which industries have we picked up. In the healthcare space, irrespective what's happening out there with economic uncertainty and slowdown and everything else, if you're unwell you have to go to hospital and you have to get treatment. You can't... It's not an election thing, it's not discretionary, it's something you're going to have to do, and so I think that if you build your portfolio accordingly you should be able to withstand some of the shocks and your trade is a consistent sort of performance. You're not going to be up when the times are great, but you're not going to be down when things are a bit worse. Again, the companies are high cash flow conversion, low CapEx, and so I think we've been very selective and I think our portfolio seems to be holding up pretty well.

Tyler Gately: Yeah. I mean, I think to put it a different way it's really identifying assets that have a reason to exist in all parts of the cycle. I think it kind of goes back to a common theme that we've touched on already and I'm sure we'll touch on again, but it's around sector exposure. I think a lot of us across the Barings strategy and our investment philosophy is carving out a lot of consumer- related businesses that may have some ebbs and flows in terms of just consumer demand. We're also carving out in North America, for instance, some of the heavily reimbursed healthcare where we can protect ourselves against various kind of risks of disintermediation within that five to seven year contractual maturity, which tends to be the standard of the market. I think there's also a necessary kind of humility to look in the mirror. We're not going to be immune. I think from a margin standpoint we've been pretty fortunate thus far be able to pass through price increases that Adam alluded to, but I think most recessionary environments are going to be most acute to certain parts of the economy. I think the question is just what that contagion looks like and kind of the different parts of the economy that it spreads to. So far we've been incredibly resilient and I think positioned remarkably well, but I think it's a diligent approach to underwriting on the front end and then maintaining that underwrite and that oversight from a portfolio management standpoint.

Natasha Sahi: Maybe picking up the thread on not being immune, so we've kind of done all of this stuff up front but clearly there are going to be challenges. What is your expectation around defaults across the border market, but also within the Barings portfolio? And in this environment of higher rates, what are you seeing happen to capital structures or sponsors asking for more terms of PIK? What's kind of happening at that kind of capital structure level as well? Adam?

Adam Wheeler: Yeah. There's a couple of things in that question. I mean, in terms of where do we think the portfolio is going to go I think things have held up well, but I do think, as Tyler picked up on, I keep expecting to see the quarterly numbers deteriorate from the portfolio and they really haven't yet. I think what we're going to see first really is the impacts of interest rate on borrowers before we really see a decline in EBITDA. If we look across the entire book, and I think it's true not just in APAC but in the US and Europe, EBITDA margins across our entire book have held up incredibly well so that says performance is okay, but cash flow generation is the issue. A big chunk of the portfolio has interest rate hedging in place. That will run off sometime next year, so we will start to see cash flow getting tighter on the book. You can't help it. I think what we've tried to do is position ourselves at the conservative end of the risk spectrum for this asset class. There is no getting away from the fact that this is a sub- investment grade asset class, but I think we are at the conservative end of that risk spectrum, for the want of a better way of describing, so the capital structures we have in place are not particularly aggressive. I think what you will see is companies with aggressive capital structures basically will have a broken balance sheet and they're going to run out of cash. I think that's going to happen over the course of the next 12 months, so you're going to start to see different managers with different approaches to the asset class have different performance. In terms of structures that we see today, you just can't support the level of debt that once went into these transactions so you're seeing significantly less leverage, pricing has widened out, and we can talk about that later, but I think we're getting some pretty decent risk- adjusted returns in the asset class with very limited reduction in enterprise values to date, so just more equity going in, less debt, definitely a transfer of return from equity to debt.

Natasha Sahi: Maybe kind of delving into the competitive environment then a little bit more, we sort of picked up on that thread of what's pricing looking like, you've given sort of the bird's eye view. Tyler, Justin, does that kind of echo in your regions? What are you seeing in North America and APAC as well?

Justin Hooley: Yeah, look, I mean, APAC is quite interesting because I think it's really been quite far behind, actually, on the institutional lending side versus Europe and the US. We're probably still I would say five years behind in terms of volume. To give you an idea, at the moment probably less than or 10% out of all financing is probably from institutional players versus the US I think it's the other way around. It's more like 85, 90% is from institutional players and 10% is from the banks. So the banks have played a really important role up until now, but we've had a bunch of global credit funds coming into the market. What that's done is it's provided... It's a double- edged sword. One, it's provided a lot more competition so trying to do deals has become harder because you've got a lot of capital chasing fewer deals, but on the other hand you've now been able to present to sponsors a real viable solution to say, " If you want to look at a unitranche or an institutional product, you can do it because we can get volume." We've had a couple of deals this year that have been sort of a billion dollars plus in unitranche lending, which is very unusual first for that market where you can actually fill that gap, but what's been fascinating versus the US is that the guys coming in to date, and let's see how that changes, have been pretty disciplined. They've held their pricing, they're all trying to chase deals, but people seem to be holding the pricing. The terms seem to be still pretty good I think in the US for some of these bigger companies which we're putting unitranche financing into. They would be a cov- lite uni in the states. In APAC, it's almost this unspoken thing of, " We're not going to do that. Let's actually carry on and maintain the covenants as long as we can." We have seen the benefit of the pricing going up with the terms remaining pretty good at the moment. Does desperation creep in at some stage when the guys have been down there two or three years and haven't built out a portfolio because it's hard to do that? Maybe, but at the moment it feels like it's a good place for us.

Tyler Gately: Yeah. I think in North America deal flow still remains relatively subdued. I think it's hard to read too much into the overall trends right now just because the activity hasn't been there. I think the question's really revolved around what's financeable in the market, so I think the quality of assets has remained relatively high and because of that you've seen, as Adam alluded to, EV multiples remain relatively insulated from the broader dislocation in markets. But I think in terms of the private credit side and addressing the limited supply, I think more and more tier one sponsors with tier one- type assets are consolidating around fewer, larger, more stable managers. I think that's a common theme across the market in North America, Europe, and APAC, but I think especially in North America there is no shortage in competition. But I think the reality is, especially through COVID and a lot of the turmoil in the market since then, most top- tier private equity firms are focusing their deal flow and focusing their lender relationships around entities that they view as a through the cycle entity, so they need somebody that can support their strategy, support their growth for that business, and those players are fewer and far between.

Justin Hooley: I think you're right. I mean, that's a very important part is the sponsors are going out and saying, " Okay, if I want to try and put together few lenders for this deal, I want to keep them as few as possible, so who can do the bigger tickets as well as that speed and certainty and reliability?" That hold size is key, and we are seeing that all over I think where they only want to either deal with one party or maximum sort of two or three. Some of the smaller guys, at least in APAC, that have started up and cannot provide as much of the capital structure are missing out on deals and actually having to do... We've turned down a number of deals this last couple of weeks, which these smaller guys are having to do because they don't have another chance. They can't get into the better quality assets, the tier one assets and tier one sponsor.

Natasha Sahi: I guess that's really a segue into manager performance and dispersion, right? You would've seen that dynamic recently, but we've been seeing that over the last few years as well as people have been building their portfolios and investing. Maybe just, Tyler, from your perspective, are you starting to see whispers of more dispersion across managers as well in the US market or is it just too early to say at the moment?

Tyler Gately: It's tough analysis, honestly. It's still such an opaque asset class. I think in North America, one thing we do have in terms of transparency is the BDC market. That being said, valuation methodologies, reporting of underperforming assets, it's all manager specific and there is just a very wide range in terms of transparency from manager to manager. That being said, absolutely starting to get the sense of underperformance starting to shake out. I think with this asset class and given the fact that you can continue to amend and extend and kind of kick the can down the road so to speak, I think you are starting to see some of the pain that was probably masked from 2020 and 2021 that has really kind of taken it on the chin, if you will, in terms of rising rates and broader recessionary backdrop. I think the biggest trend that I would look to is a lot of the cash interest to PIK conversion. I think in doing that, you're stemming some of the cash needs of the business. However, you're aligning your success with equity and you're kind of taking your current income product and aligning with an equity takeout, which is going to continue to draw out performance and candidly I think will be probably the biggest separator of performance between kind of top tier and discipline managers with kind of those that were maybe less disciplined in the good times.

Natasha Sahi: I guess, Adam, maybe just picking up on that, the outlook for Europe, given the portfolios are more discrete as well across managers, what do you expect there? Generally speaking, what are the implications of all of this for the asset class?

Adam Wheeler: Yeah. It's interesting to compare and contrast the European landscape with North America. I think the BDCs do give more transparency to manage performance in the US. I think it is more opaque in Europe, and I think, to Tyler's point, it takes a long time for issues to flow out. I think managers in Europe have a range of valuation policies, and sometimes those valuation policies result in very little movement in NAV until there is a major, major problem. I think a lot of people are trying to hold the tide back, and I think as cashflow becomes tighter and businesses start to underperform you will start to see quite a divergence in performance. That's down to your point around managers in Europe having... Because it is a bit of a sole lender market, generally is, and particularly in the space we're in, you will see managed performance vary greatly because of that. But it's really what did you do two or three years ago will determine what your performance is over the next 24 months because it just takes so long for it to come through. I think one of the key things today in Europe around that sole lender market is just access to quality deal flow. As Tyler said, there's fewer managers doing more transactions, raising more capital. If you're not in the flow, if you're not one of the two or three direct lenders that a private equity firm wants to go to, you're basically going to get adverse selection. I think adverse selection is going to become a massive, massive issue in direct lending. You want to invest with someone who can give you access to high quality flow. I think that's the most important thing when an LP is looking at a manager today is are you seeing the high quality flow? Do you have an opportunity to invest in quality businesses or are you getting everything that everyone else says no to?

Natasha Sahi: I've got a tough question for you now. How can an LP actually diligence that?

Adam Wheeler: I think it's really, really hard, and I think everyone in this asset class sounds very, very similar. Everyone says we invest in what we've been talking about, assets that perform through cycle, we avoid cyclical businesses, I think that message has narrowed over the last couple of years as people used to have a broader mandate and discovered that some stuff didn't work. So I think the first thing is how has their investment philosophy changed over time? Are they doing today what they've done in the past, and how has that changed? Do they actually follow through and say they do what they will do? Most people say one thing and do another, and then you can see big variations in portfolio vis- a- vis compared to what they actually have in their portfolio. And I think just looking at some raw things like debt to EBITDA numbers, what's the actual interest cover coming out of it? The other really objective thing you can look at is just levels of diversification in a portfolio. It's pretty hard for people to make up the numbers in a portfolio, but when they're looking at adjusted EBITDA and leveraged numbers there's a lot of managing of that, but it's more the soft stuff. You've got to dig in and ask detailed questions around, " What are the type of businesses? Why do you like the business?" Then go and due diligence that with private equity firms and see what they say about particular direct lenders.

Tyler Gately: One thing that kind of jumped out to me is there are probably, what, 75 direct lenders in the market today, if not more, but I think you could really group them in two different categories. One is being kind of an alternatives manager, and I think those individuals have probably strayed because they look at a transaction and they want to structure around every risk and they want to squeeze every last basis point of return out of it. Then I think there are managers that look in the mirror and acknowledge that we're first lien senior lenders. It's not the most exotic thing in the world, but it's a view of principal preservation is how you return a fund, not stretching to win a deal and squeeze everything out of it. I think if you look back over the past couple of years, that bifurcation is really what's going to drive manager performance. To Adam's point, you're going to see that in leverage, you're going to see that in interest coverage, you're going to see that in types of deals done, the change in investment philosophy, the change in position in the market, going from traditional to upper or getting squeezed back down to lower. I think there are a lot of data points, but I think, to my point earlier, looking at cash to PIK conversion is going to tell you a lot.

Natasha Sahi: Maybe switching to kind of your forward- looking perspectives, what are your bull and bear cases for the asset class over the next 12 months? What's the glass half- full view, I'm going to throw that one over to you, Adam, and what's the glass half- empty?

Adam Wheeler: You're starting with me on half- full?

Natasha Sahi: Yeah.

Adam Wheeler: That's surprising.

Natasha Sahi: Yeah.

Adam Wheeler: Yeah, look, I think a lot of performance is going to come down to liquidity in the short term, and that means is the interest rate burden going to be maintained, as in a base rate's going to remain elevated for a longer period of time? Look, the bullish case is that we've peaked in interest rates, it starts to come off, there's more free cash flow, uncertainty starts to fade, M& A activity comes back, and then the industry starts to deploy more money again, equity multiples remain okay as a consequence of that fall- off in interest. That's the bullish case. I'm predicting that that's probably... I think interest rates are going to stay higher for longer. I think you're going to see liquidity, I think you're going to see peaking of staff, I think you're going to see businesses with broken balance sheets, which is going to represent an opportunity for us on the credit side, and I think you're going to see private equity firms... A big dispersion in private equity performance, and I think in general you're going to see a transfer of return from equity to debt, which hasn't happened for over a decade. I gave you both.

Natasha Sahi: You gave me both. Anyone else want to add their views, bull and bear case?

Justin Hooley: Look, I think it's not going to be that dissimilar. I think one of the interesting things, which is still the play out, I think, in APAC, is more what's happening in China because that is actually such a big economy and has a really large impact both locally on Australia but also the rest of the world. I think there's a lot of pain going on in that. There's government seems to be throwing more stimulus at it now and trying to get people to carry on lending and opening that up, but I think that that to me will decide, at least in our area, what happens on the bull or the bear case because that could have big ramifications for everybody depending on which way that goes.

Natasha Sahi: Tyler, what is your...

Tyler Gately: Yeah, honestly not too dissimilar. I mean, I think I look at the asset class bull and bear as really being focused on deal flow. I think performance is going to be shaken out manager by manager, and I think for better or worse those beds are already made. But I think in terms of deal flow bull case, everything that Adam said. I think there could certainly be a thawing in the market and private equity has pent- up demand and pent- up desire to achieve liquidity. I think a bear case is... It remains subdued. I think there's still a lot of uncertainty in terms of valuations. We've talked about the tier one assets where valuations haven't moved a lot. Everything's not a tier one asset. I think there's going to be a lot of hesitancy to go out and monetize a tier two, three, four, however low those numbers go, and I think that could continue to maintain a little bit of a slowdown in the M&A markets.

Natasha Sahi: With that kind of framing, if you were to provide guidance to investors on how to navigate the outlook what would your recommendations be? How should they be thinking about their allocations for 2024? Tyler, let's go back to you.

Tyler Gately: Yeah. I think from a macro perspective, the asset class continues to grow and for a lot of good reason. I think there will continue to be a growing opportunity set as private credit effectively plays out the same playbook as private equity since the'80s. That cannibalization trade of syndicated markets will continue. I think the market opportunity will grow, the attractiveness, the economics, obviously in a base rate environment that we're operating in today incredibly attractive on a risk- adjusted basis. I think in terms of navigating that, I think scale matters. I think liquidity matters. I think looking at a private credit allocation, similar light as choosing a bank. We're banks in that regard, and you want somebody that's going to be there in all parts of the cycle and able to lean into that opportunity, so consistent with comments I made earlier you're going to see LPs, you're going to see deal flow from sponsors, you're going to see talent consolidate around inaudible larger. I think you have to go into it eyes wide open and really focus on manager selection, but ultimately that is my prediction in terms of how that plays out.

Justin Hooley: I think the important thing for the LPs to really do is work out, I think Adam touched on it earlier, which part of the risk spectrum they want to be on. Are they in the conservative, defensive, capital preservation but earning a return here or do they want to go on the riskier side and play the riskier side and get the alpha and are prepared to take that chance to get the alpha? Then once you've worked that out, I think you can then try to group managers into those buckets of people who offer that sort of stuff, but that's very important because I think if you don't really know what you're trying to achieve, as we say, but private debt has become very, very popular as a term, at least in APAC. Everyone's talking about it, everyone wants to invest in it. There it's always been the 60/40 rule. That's changing now. I think people are realizing that the private asset class is not a bad asset class to invest in, it actually has quite a few advantages, but then when you get into it that you've got to peel the onion back and actually work out which part you actually want to sit in before you deploy.

Adam Wheeler: Yeah. I mean, it's still a relatively new asset class for a lot of institutional investors, and I mean LPs. I think by and large, the experience that people have had with the asset last over the last sort of five to 10 years has been positive. It's gone from being more of a niche- y allocation to a permanent allocation within institutional investors' portfolios, so that means there's going to be more capital flowing into the asset class looking for a home. To Tyler's point, that means there's a structural shift in the asset class growing. It's definitely going to start to eat into public markets, but you are going to see a bifurcation of manager performance so you're going to see that growing faster than the industry. I think there's going to be... You're already seeing fewer managers inaudible larger funds and doing more of the deal flow. I think that trend will continue, so what's going to become more important over the next cycle is manager selection and going with people that you see high quality flow, that do have scale, to Tyler's points. Incumbency is incredibly important. A lot of your deal flow comes from your existing book today. All those things mean in my view you've got to pick who you want to be with. You can't just go and say, " Here's 10 managers in Europe. We'll give them all a ticket. They'll all do similarly." That's not going to be the case anymore. You will see people blow up and lose money in the asset class.

Natasha Sahi: You might have already given your bold prediction for 2024, but lightning round. One bold prediction from each of you for the next year.

Adam Wheeler: I think you'll see M& A activity come back by sort of beginning of Q2 because not my bull or bear prediction, just because private equity firms are going to be under a lot of pressure to return capital to their investor base so those that investors can come into a new vintage for that private equity firm. As a consequence of that, you're just going to see that valuation gap erode between buyers and sellers and people are just going to have to move stuff. I think that's what I think will happen in the first sort of three to five months of next year.

Natasha Sahi: Justin?

Justin Hooley: I'll go light- hearted and then make it serious. I think Novak Djokovic is going to win two Grand Slams next year.

Natasha Sahi: That's bold.

Justin Hooley: That's pretty bold, I know, but given his age... So no, no, not four. No, no, no. I'm conservative. But on a theme along those lines, I think inflation is going to stay higher for longer. It's going to be tougher, like Djokovic is, hanging in there and really annoying people and trying to win stuff. I think the rates are not... I think everyone was hoping it was going to be a quick up and down in the rate cycle. I think we've seen that it's still got a way to play out.

Natasha Sahi: Never heard a comparison of Djokovic and inflation before. That's a good one. Tyler, what about you?

Tyler Gately: I'm going to say I think we'll start hearing whispers of regulatory oversight to private credit, although I would say I think that's going to focus on the retail investor. I think there's been a tremendous amount of growth out of that with mixed experience, and I think it's probably prime for a little bit of oversight there.

Natasha Sahi: Well, thank you, guys, for that session. It's been really great to spend the time with you going through your views and perspectives from across the region. Hopefully to everyone that's dialed in that's helped to bring into focus some of the themes that we felt were uncertain and blurred at the start of this conversation. As ever, please reach out to your Barings representative if you want to follow up and continue the conversation with any of our speakers here today. Thank you all for dialing in and also would encourage you to subscribe to the Streaming Income podcast and check out the Barings website for more information on any of the themes that you've heard here today. Thank you very much.

Speaker 1: Thanks for listening to this episode of Streaming Income. If you'd like to stay up to date on our latest thoughts on asset classes ranging from high yield and private credit to real estate debt and equity, make sure to follow us and leave a review on your favorite podcast platform. We're on Apple Podcasts, Spotify, YouTube, and more. We publish a new episode every other week. If you have specific feedback, you can email us at podcast @ barings. com. That's podcast @ barings. com. Thanks again for listening, and see you next time.


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