For years, financial investors benefited from the European Central Bank's zero interest rate policy. In the search for returns, billions in institutional capital flowed into the private equity and private credit asset classes. Large-volume and cheap loans enabled investment firms to buy expensive companies – and then sell them on at an even higher price. But a lot has changed since summer 2022.

„The market has changed substantially since interest rates have risen,“ says Matthias Mathieu in the private markets podcast „Betting Billions“. The co-founder of the Bright Capital credit fund has observed three main patterns of behaviour among institutional investors in current fundraising processes: Firstly, more capital is flowing back into fixed-interest securities. Secondly, investors are focussing more on large and established credit fund managers. And thirdly, away from the big names, specialised managers with a demonstrably good credit book are in demand.

Mathieu is particularly critical of the part of the market where there was the greatest competition in the past. The high pressure to invest meant that the credit conditions were not always chosen correctly. As an example, Mathieu cites unrealistic assumptions about future operating earnings before interest, taxes, depreciation and amortisation (Ebitda), which serves as the basis for the leverage ratio granted by credit funds.

In the case of aggressive financing, Ebitda was calculated to be higher than it actually turns out to be, in the expectation that the company would grow strongly in the future. However, if these assumptions did not materialise because the macroeconomic environment has deteriorated, then financial investors with aggressively structured loans now have a problem. The company's debt is then not 6 times the operating profit as initially thought, but actually 9 times.

If, on top of this, the documentation had been softened and the loan granted without strict credit control clauses, then, according to Mathieu, the actual leverage today may even be 12x EBITDA. If things don't go as planned, one thing is clear: The equity (i.e. the private equity investor) will definitely be out of the money, but most likely the debt (i.e. the loan fund) will be as well. „Nobody wants to realise the losses,“ says Mathieu.

For this reason, many financial investors push the problem into the future. This involves capitalising the interest payments spread over the term of the loan, and postponing them to the end of the term – in the hope that by then interest rates will have fallen significantly again, company profits will have risen again, and the loan can be refinanced.

Mathieu considers this positive scenario to often be quite realistic. In his opinion, the companies financed by credit funds have tended to be good companies. Credit funds have held back from the really cyclical themes. However, the possibility that the private credit boom has produced a few zombie companies that will not make it in the end cannot be ruled out.

Mathieu, therefore, advises investors in the current market environment to always ask about the true Ebitda and the ratio of cash to PIK interest. How much interest is paid out on an ongoing basis, and how much is only paid out at the end of the term? After taking a closer look at the loan portfolios, one might come to the realisation that many companies that are not yet on the watch list today might not be doing well anyway, even if the covenants have not yet kicked in.

The return of higher interest rates is thus revealing winners and losers. So far, private equity has tended to be on the losing side. „Higher rates have ultimately led to more money flowing out of companies,“ says Mathieu. Among the credit funds, those that are dependent on private equity are particularly likely to have problems. According to Mathieu, typical direct lending funds have found success with investment companies in the past with two arguments in particular: Bullet financing and higher leverage.

The rise in interest rates would set natural limits on debt leverage, as this would mean that a company would no longer be able to take on as much leverage. Maturity financing without ongoing debt servicing is interesting when a company is growing rapidly. Both arguments are losing weight in the current market environment. At the same time, Mathieu points to the sound banking system in Germany, and questions whether private credit will really still be the preferred financing partner for private equity if the accepted leverage ratios of credit funds increasingly approach the lower level of banks.

In the past, credit funds have ultimately had to pay for the outcome of the higher leverage ratios, and were consequently significantly more expensive than a bank. „Private equity has always turned over every stone to optimise returns, but today it is probably more necessary than ever,“ says Mathieu. So when the M&A market picks up again, he can imagine a private equity investor initially paying for a transaction entirely out of their own pocket, and then taking their time to obtain conservative financing from a bank.

For Mathieu, this means that credit funds will either have to move closer to the pricing level of banks, or look for more transactions outside the private equity business. Bright Capital favours the second option: Eight out of ten transactions are currently carried out without a private equity investor. Instead, the focus is on smaller succession solutions in which the management takes over the company. In the background, the transactions are often supported by a family office with equity capital.

A buy-and-build strategy would then be pursued. The initially financed company buys up smaller competitors, ideally creating a larger company that can later be sold at a higher price. Bright Capital supports these acquisitions and, according to Mathieu, can provide between 5 and 50 million euros as debt capital for such a project.

However, the buy-and-build approach without a financially strong private equity investor behind it only works for smaller companies that still have comparatively low valuations. These are usually companies with enterprise values of 10 million euros or more. With this approach, Mathieu believes he can differentiate himself from other credit funds. The coming weeks and months will show whether this is successful. Bright Capital is in the process of raising money for the third credit fund. According to Mathieu, the target volume is based on what Bright Capital has already invested in recent years: 300 million euros.