Private Junior Debt: The Intersection of Syndicated and Private Corporate Credit
The growth of private credit as an alternative to syndicated markets is one of the most dramatic developments in credit markets over the past decade.
As my colleagues Chris Sheldon and Rory O’Farrell recently wrote, “We think a common portrayal of the relationship between private credit and liquid credit as a PacMan game wherein one side tries to eat the other for lunch is flawed. Going forward, we think the challenge for investors will be to find the equilibrium between these two markets.”
Issuers will face a similar challenge, and in our view will turn to accessing both markets simultaneously through the application of syndicated senior and private junior debt to construct their balance sheets. We think the shift to this hybrid syndicated/private approach will be propelled by syndicated markets reopening into very different conditions than existed just a few years ago, creating a gap that private junior debt is likely to fill. We believe that investors and issuers alike can benefit from private junior debt becoming a more integral part of the market.
M&A Volume Ramp
In 2023, global M&A volume hit a decade-long low while private equity dry powder reached an all-time high (Exhibit 1). Together with a firming of credit markets, the conditions are set for a resurgence in transaction activity.
We think syndicated markets will continue to be a source of financing for larger issuers, who can best capitalize on the efficiencies these markets offer. These markets have also become more attractive of late, as spreads have tightened within the last four weeks, reverting close to 2021 levels. In mid-February 2024, spreads on leveraged loans issued to BB or BB- borrowers SOFR +250 basis points (bps) and SOFR + 370bps for B or B+ rated transactions (Exhibit 2). These levels are about 30% lower than the recent peak spreads in each cohort and make it attractive to finance leveraged buyouts with syndicated product. Indeed, broadly syndicated loan issuance in January was higher than at any time since November 2021.
EXHIBIT 1: Private Equity Dry Powder
EXHIBIT 2: Institutional Leveraged Loan Spreads (bps)
The Intersection
Does this resurgence of leveraged loan issuance indicate a shift away from private credit back to syndicated markets? Not necessarily.
We continue to view senior direct lending as a fixture in corporate financing of upper-middle market borrowers as KKR’s Global Head of Private Credit, Dan Pietrzak recently noted in an interview. The flexibility of private credit, combined with the relative simplicity of dealing with a single lender, will remain attractive to many borrowers, in our view.
As capital markets reopen, we do expect larger, rated borrowers to pivot back to lower cost syndicated loans and bonds to finance the senior part of their capital structures. However, best-in-class companies that trade at premium multiples may run into a gap in capital structures between the amount of senior debt available and the quantum of equity a rational shareholder can or will invest to capture an “equity-like” return. Often, private junior debt will be the best way to fill this gap (Exhibit 3).
EXHIBIT 3: A Typical Capital Stack with Private Junior Debt
In this way, private junior debt represents how syndicated and private credit markets work in tandem to deliver an attractive financing solution.
Benefits of Private Junior Debt
To be a viable financing solution, private junior debt needs to benefit both issuers and investors, and we think there is a good case to be made in both instances.
Issuers
1. Leverage: Going forward, we expect that syndicated senior financing will account for a lower percentage of a company’s capital structure due to the mechanical effect of higher interest rates and spreads, as well as rating agencies focusing more intently on coverage ratios. Private junior debt can be structured to fill this gap with equity-like features that are sensitive to the concerns rating agencies have about debt ratios.
2. Cost of capital: Combining lower levels of rated senior debt and new private junior debt likely will result in a cost-of-capital advantage given improved syndicated market spreads. Pre-placing the most critical junior portion of the capital structure can also offer higher certainty of execution.
3. Customization: Lenders can develop bespoke covenant documentation for private junior debt with issuer objectives in mind. This affords companies flexibility, allowing the balance sheet to accommodate value creation plans in a way that syndicated financing often cannot.
Investors
1. Diversification: We see opportunities for allocators to use junior debt as a diversification tool for private credit allocations. It gives access to far larger borrowers than one would typically see in a direct lending portfolio.
2. Enhanced returns: Private junior debt also offers a meaningful yield pick-up of 300-400 bps relative to syndicated senior debt and 200-300 bps relative to senior direct lending.
3. Call protection: Private junior debt has more significant call protection than senior debt. In our experience, private junior debt deals have expected multiples of invested capital of 1.4x-1.8x, and occasionally more (Exhibit 4).
EXHIBIT 4: Illustrative Example of MOIC for Private Junior Debt
4. Fixed vs. floating: We expect that up to 50% of junior debt investment opportunities will have fixed interest rates. That should be particularly attractive to investors in 2024 as markets focus on the timing and pace of rate cuts by central banks.
Conclusion
The growth of private credit does not diminish the need for syndicated credit markets. Both play key roles in providing options for issuers and can serve different purposes. We think private junior debt will be an increasingly key ingredient in capitalizing a company’s balance sheet as public and private markets converge — a means for them to complement one another. Moreover, we see the asset class as an attractive proposition for issuers and investors alike.
