In a panel discussion during the Stout Summit: Investment Funds and Alternative Assets 2023, Rodney Lacey, Managing Director in Stout’s Valuation Advisory group, led a discussion on the environment impacting debt and equity market returns, with a specific look at the acceleration of risk related to the interest rate, regulatory, and macroeconomic environment.

Five key takeaways emerged from insights shared by the panelists, who included:

• Brett Hickey, Chief Executive Officer, Star Mountain Capital
• Joyce Choi, Director, Fixed Income Product Strategy, BlackRock
• Vadim Avdeychik, Partner, Clifford Chance
• Owen Pinkerton, Partner, Eversheds Sutherland

1. The interest rate outlook is uncertain amid economic shifts and inflation pressures.

Since March 2022, the Federal Open Market Committee has focused on addressing inflationary pressure in the market, raising the Fed funds rate almost a dozen times over the past 18 months. Though inflation has begun to wane in certain aspects, we’re likely still far from the long-term inflationary target.

Many expect interest rates to remain high for at least the next year, though predicting this is uncertain due to various global and economic risks. If a recession occurs, the government may need to lower rates, but for now, stability is expected with a possible slight increase. Notably, earlier assumptions of a recession seem to have been wrong. Some now suggest potential growth in 2024 or stabilization.

In the current environment, investing in debt appears favorable as public equities have a low-risk premium. Debt securities are seen as a defensive option during economic challenges, and the duration of debt capital has improved. In the market, challenging credits can struggle to secure funding, while good deals still happen.

Market conditions are currently challenging, with expectations of rate cuts starting in March 2024. Despite market cracks like increased bankruptcies and tighter bank lending, inflation remains elevated due to geopolitical tensions and rising oil prices. This may necessitate the Fed’s vigilance, possibly leading to higher rates or prolonged high rates compared to current market expectations.

2. Controls remain vital.

Implementing controls in anticipation of forthcoming regulations and a tightening economic landscape is crucial. Poorly structured funds hold a variety of pitfalls, such as hedge funds holding illiquid assets in liquid vehicles, resulting in forced sales of potentially valuable assets during unfavorable times. Excessive leverage can also create risk, such as in 2020, when entities like business development companies had to undertake equity capital-raising activities to avert significant problems for equity investors.

Companies should ensure that interests are properly aligned. Understanding who is motivated to take what actions will highlight conflicts of interest in financial dealings, especially when historical economic growth can lead to oversight of fundamental interest alignments.

3. Proactively prepare for market volatility and evolving regulations.

Businesses should proactively address volatility rather than waiting for sudden market turbulence. The proliferation of private credit and market products targeting non-institutional investors highlights the need for adequate education to those investors. Regulators such as the SEC are closely monitoring the situation, particularly concerning deal structures’ ability to handle volatility, as the security of collateral becomes a key concern.

Proactivity also applies to potential regulatory changes. Private funds should consider the impact of adjusting regulations, especially as the gap between private capital and public market regulations narrows. The SEC’s efforts to protect both retail and sophisticated investors mark a shift in perspective from historically primarily focusing on retail investor protection, and this evolving regulatory environment presents challenges and uncertainties for businesses operating in private markets.

4. Private debt capital is on the rise.

Private debt capital has risen due to a strong emphasis on covenants, controls, and structures in the market. While some experienced managers can navigate market changes effectively, many investors seek opportunities where there are robust covenants and expertise in managing loan workouts.

Supply and demand dynamics also play a significant role in the rise of private debt capital, especially in the lower middle market, where smaller loans may be less appealing to large banks. With many business owners in this segment aging and a growing demand for liquidity, private credit becomes an attractive option as traditional bank funding in this space diminishes.

Additionally, the current low-interest-rate environment has led to increased demand for private credit, with investors looking for sound investments in businesses with promising acquisition opportunities and growth potential. Benefits like upfront fees, exit fees, and potential equity upside through warrants or structured equity make it an attractive option for taxable investors seeking asymmetric return potential and long-term capital gains when companies perform well.

5. ESG regulation continues its evolution.

The rollout of environmental, social, and governance (ESG) related regulatory initiatives appears to be in mid-process, with evolving disclosure requirements posing challenges. The SEC’s actions could accelerate this process, including proposals for corporate climate and ESG fund disclosure. However, these rules’ complexity has caused delays and faced pushback from various industries.

California’s climate-related risk reporting requirements are still aspirational, with their actual impact on investor returns uncertain. To ensure ESG strategies are implemented, investors should focus on setting honest KPIs and monitoring sustainability-linked loans’ covenants and criteria.

Sustainability-linked loans may become more prevalent, depending on market dynamics and investor risk appetite. These bonds, more common in Europe, involve interest rate adjustments based on ESG milestone achievements, impacting bondholders. The popularity of these bonds may be influenced by prevailing interest rates.