UK: Should You Use Non-Payment Insurance To Combat The Macroeconomic Pressures On Private Capital?

As commentators highlight the challenges higher interest rates pose for private credit funds, why might non-payment insurance support competitive advantage?

"The benign climate has changed with higher rates, wider credit spreads and slowing revenue growth, all of which is likely to put pressure on many managers' portfolios," so reported the Financial Times. It described private credit as an industry growing into its "golden moment" while also facing new challenges in the higher interest rate and inflationary environment.

With the outlook for rates remaining higher for longer will likely see more companies grappling with refinancing debt, in this insight, we examine private credit funds' search for alternative strategies.

How can your private credit fund counter the impact of interest rates and inflation and could non-payment insurance help your private credit fund weather the current macroeconomic backdrop?

What's the current state of private credit?

The period of ultra-low interest rates is over. What's on the horizon is a prolonged period of lending, fixed income investing and credit investing, so said billionaire U.S. investor Howard Marks. Although this provides opportunity, Marks told The Business Times, "There will be a period in the future, sometime within the next 10 years, when the impact of leverage is [magnified losses]."

Marks expects owners to unload securities as concerns drive an eagerness to exit at any price when economic events turn against them. This is where a well-executed insurance strategy could be beneficial. This is particularly the case for transactions where the underlying asset is fundamentally solid but is not priced at levels that reflect intrinsic value.

How are increased interest rates impacting private credit funds?

The rise in interest rates presents challenges for private credit on multiple fronts:

• Higher default risk: Elevated interest rates increase the risk of default for companies backed by private capital. These firms may struggle to service their debts, leading to financial losses for the private credit firms involved. This heightened default risk adds complexity and risk to private fund investments.
• Decreased valuations: Higher interest rates can lead to decreased valuations as businesses face increased borrowing costs, potentially resulting in decreased valuations in net asset value (NAV) facilities and the ability to obtain credit on a fund's own subscription lines.
• Increased borrowing costs: Higher interest rates make it more expensive for private credit firms to borrow money on subscription lines and bank financings, which can hinder their ability to complete deals.

All of the above is contributing to slowed-down deal-making and, in some cases, leading to bankruptcies of borrowers using private credit and private equity owned companies. Bankruptcy filings by private equity and venture capital-backed companies in the U.S. surged to 104 in 2023 from the 38 U.S. portfolio company bankruptcy filings in 2022, with many citing increased corporate borrowing costs, inflation and supply disruptions.

How can private credit funds respond to high interest rates?

There are a range of strategies private credit funds can use to counter the current macroeconomic pressures. One is to explore new markets, either in different emerging market jurisdictions or new sectors.

Key sectors for private fund investments include software, tech, healthcare and financial institutions, with an emphasis on high-quality assets in uncertain economic times. Manufacturing in particular, has re-emerged as an active sector.

Alternatively, private credit funds can consider focusing on globally resilient sectors, particularly where organizations have strong environmental, social and governance (ESG) integration, such as clean energy and renewables.

We've also witnessed the increasing popularity of insuring fund finance transactions, including using subscription line and NAV loans.

Turning to credit funds and non-bank lenders is a further strategy some private equity firms are choosing to address reduced bank lending. Evidence from Deloitte suggests 40% of deal participants are turning to credit funds and non-bank lenders, while 17% require additional lenders for their transactions.

How non-payment insurance could be private credit funds' ace in the hole.

While historically, private credit funds have not been significant buyers of non-payment insurance, the current conditions prompt a rethink. Insurance could allow you to be more proactive as conditions remain volatile and uncertain, creating a new option to continue with your investing and lending strategies with a new, alternative distribution strategy.

Many insurers you could partner with are rated AA- by S&P, non-payment insurance can shield your private credit fund from the risks associated with non-payment, providing an additional layer of security for investors and your own lenders alike. And unlike alternative risk mitigation strategies, such as approaching a banking institution or co-lending with a competitor for funding, buying non-payment insurance is a move to distribute your risk 'in silence.' You don't need to share your strategy with investors or competitors. You can also reduce the amount of yields you share with the banking partners you may have otherwise approached for support.

Non-payment insurance may prove a particularly useful alternative distribution strategy in the context of increasingly well-used NAV loans. With the market estimated to grow from USD 100bn in 2022 to USD 600bn by 2030, credit insurance can support you and provide confidence when venturing into new markets.

Having the reassurance of non-payment cover can open up new sectors or territories, supporting your wider strategy to respond to the current macroeconomic environment, as well as continued global geopolitical uncertainty.