Oaktree Capital is monitoring “pockets of potential weakness” in direct lending, some of which are creating opportunities to trade portfolios, but said that it does not believe the asset class is “broken”.
Speaking on the latest episode of Oaktree Capital’s podcast The Insight: Conversations, Brook Hinchman, head of North America, global opportunities, identified three issues that are “coming to a head” at once.
“The first is that about a quarter of the direct lending market has an asset liability mismatch where these interval funds and private business development companies (BDCs) have quarterly redemption features on what is fundamentally an illiquid asset class,” said Hinchman.
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He said that the second is “a vintage issue” as a result of the 2021 and 2022 leveraged buyouts (LBOs) being “fundamentally over-levered”. “These LBOs were done assuming that interest rates were going to be zero going into perpetuity,” Hinchman explained.
He also pointed to enterprise software as the third issue, given that “it was the sector that had the most exposure and it was the sector that had the highest level of leverage, and the highest valuations”.
The threat posed by AI to the enterprise software sector, specifically Anthropic’s Claude Code, has been making headlines recently, with concerns about private credit’s exposure to this sector.
“The primary barrier to entry for enterprise software was the ability to, one, develop code, and two, to switch your data, and to switch your processes and systems from one enterprise software to another. Those barriers to entry have come down meaningfully and it’s resulting in a wide dispersion between the winners and the losers for a category of business models that, historically, have been very stable, very sticky and very steady,” Hinchman explained.
He added that, while the firm does not think direct lending as an asset class is broken, what they are seeing “is the current subset of deals are overexposed to one challenge industry and overexposed to one bad vintage” of LBOs.
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Harry Whitelaw, vice president of Oaktree’s marketing and communications team, said: “I don’t think we believe the asset class is fundamentally flawed. In fact, the concept of privately negotiated senior loans to PE backed companies makes a lot of sense.”
Whitelaw asked Hinchman and Matt Wilson, co-portfolio manager, special situations at Oaktree Capital, whether they had seen “much in the way of secondary activity in the direct lending market”, such as limted partners or general partners trying to offload loans.
“What you do not have in the direct lending market, because it just hasn’t evolved yet, is a true exchange like you have on the trading desk in the broadly syndicated market. What you see now is portfolio trades,” explained Wilson, who added that “the information opacity is part of the problem there”.
However, Hinchman said they are seeing opportunities in direct lending portfolios that “because of the asset liability mismatch and because of redemptions by investors to meet that liquidity, we are beginning to see portfolios trade”, and that they expect these opportunities to “accelerate”.
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