By Zeshan Ashfaque and Kevin Marchetti, Man Varagon: Private credit – specifically middle market, sponsor-backed direct lending – looks uniquely positioned to weather the future storm thanks to a number of supportive structural factors.

Introduction

The last 5 years have been volatile, to say the least, with global markets getting rocked by a variety of events, including the COVID-19 pandemic, the rise of US interest rates from nearly zero to almost 5.5% to combat inflation, the short-lived US regional banking failure crisis, and increased global geopolitical conflict. It is quite likely that the upcoming US presidential election in 2024 is going to add even more fuel to the fire. While we cannot predict whether volatility will be higher or lower in the future as compared to recent history, we believe that things will be different over the next 5 years as investors look for stability and alpha in an uncertain future that may include another recession.

The most significant difference in the coming years will be the ‘higher for longer’ interest rate environment that the Federal Reserve has been guiding the market towards. The higher rate environment has had, and will continue to have, significant knock-on effects, as the market looks to adjust to the new normal from an extended period of ‘free money’ that encouraged risk taking to generate returns. These include declines in durationsensitive fixed income securities, including US Treasuries, a sharp drop in M&A volumes and valuations, rising default rates because of borrowers’ debt service burdens nearly doubling, and the threat of a pending recession as the Fed looks to combat inflation by reducing consumer spending by keeping interest rates high.

Private credit – specifically middle market, sponsor-backed direct lending – is potentially uniquely positioned to weather any coming storm while providing attractive risk-adjusted returns thanks to a number of structural factors…