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“Real estate has always been affected by interest rates,” Cahill says. “Also there has been a massive shift in the post-COVID world. Where do you really need people to go into the office five days a week? If that is a permanent shift, that asset could potentially be worth less.”
More generally, he says, investors are trying to work out whether the rise in interest rates is a permanent change in interest rates, or merely a temporary blip as central banks get inflation under control.
“I think it is more likely than not that if you believe that you are going back, or reverting to the norm, and that this is going to have a bit of duration to it.”
Meanwhile, rising interest rates is reawakening investors’ appetite for corporate debt.
“For credit, companies constantly need to refinance their balance sheets. And I think there will be some interesting credit opportunities out there generally,” Cahill says.
These, he says, likely involve “companies that either have balance sheets that are relatively in good shape or [situations where] you can use structure to box up your risk, by taking liens on specific assets and protect downside, then that can be interesting”.
So, does Cahill have a preference for credit rather than equity at present?
“Yes, generally in an environment where companies are getting their footing in this new interest rate environment, I think that probably taking a little bit more of a defensive stance or posture is probably sensible as a starting point,” he says. “Then I would look at the specific company’s situation and see what are their needs, what their balance sheet looks like, what is their competitive environment.
“And then I might move up or down the capital structure depending on the answers to all those questions.”
According to Cahill: “One of the things I think is broadly true is because debt capital is becoming a little bit more dear right now – either because it’s become more expensive, and it’s become less available – the right answer might be a preferred security.
“But there’s no reason you can’t embed in a preferred security some of the covenants you would have seen in old-style debt.”
As Cahill points out, loan covenants – whereby lenders impose restrictions on corporate borrowers – have disappeared over the past decade.
“Now everyone’s bringing them back”, he says. “But that actually might be more valuable in a preferred equity structure” where investors can earn higher returns without taking on much more risk, he adds.
So what sort of returns can investors now earn from investing in corporate credit? Cahill says that, in the North American market, “most senior debt securities – either a bond or a leveraged loan – will be in the zip code right now of between 8 and 10 per cent. That’s pretty much the norm”.
“And if you had a mezzanine piece of paper, you’re probably 200 to 300 basis points behind that,” he adds. “So call it 12 to 13 per cent.
“And if you had a preferred security, you’re probably another 200 to 300 basis points behind that. Sort of mid-teens sorts of returns.”
Cahill also points to the growing divergence between the $US1.5 trillion ($2.4 trillion) private credit market, which is now larger than its publicly traded counterpart.
“One of the things that needs to be kept in mind is that you have both the public markets, and you have the private markets and I think there’s going to be greater divergence between those two markets over time,” he says.
In public markets over the past decade, “the covenants, the protections to investors, have been competed away quite dramatically”.
“And you’re certainly going to see them come back, but they’re probably going to come back to a lesser extent than the private markets,” he says.
The reason, he adds, is that “if you’re investing in public debt, you have an exit already, where you can just trade the security. That’s the benefit of being in a public security”.
In contrast, he says, investors in private markets don’t have an easy exit, and are there until the security matures, or there’s some sort of restructuring.
“[As a result] the protective measures in private credit have historically always been more fulsome than the public markets and I think they’re going to become a lot more fulsome.”
So why would a company tap private credit markets?
Cahill points out that it’s expensive for private companies to issue public securities, and the debt raising has to be of a certain size.
“So there are all sorts of private companies that don’t really fit in the public markets naturally anyway.”
Cahill adds larger companies are now tapping private credit markets, after banks pulled back from lending in late 2021 and early 2022.
“Some of the institutions – some of the investment banks and commercial banks – that would normally put together public securities started to retreat, because of certain things they already had on their books,” he says.
“And as a result, that allowed some of the private credit providers to step into the marketplace and act as a substitute.”
Cahill also points out that a lot of the growth in private credit has reflected the fact that private equity funds are increasingly migrating from pure private equity to private credit.
Meanwhile, regulators are becoming increasingly worried about the potential risks lurking in the sprawling, unregulated private credit industry
“I definitely think it’s a concern. It’s a little bit of a cause and effect relationship, though. In some ways, they’ve created that outcome because the existing regulatory footprint has pushed people to the edges.”
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