“Capital is destiny.” We’re not sure this pronouncement will make it into the next edition of Bartlett’s Familiar Quotations, but the notion sprung to mind as we recently addressed a top business school class. Topic? How private equity sponsors finance leveraged buyouts.
To show students how debt markets work, we discussed how issuers benefit when investors deploy cash in various asset classes. Cash flooding into retail loan mutual funds (as is happening today) causes spreads to compress in the broadly syndicated market. Issuers can then refinance existing debt at lower costs, or come to market with new deals at attractive all-in coupons.
The reverse is also true. When investors exit from high-yield retail funds (almost $5 billion have done so year-to-date), junk bond spreads widen creating headwinds for new bond issuance.
The more liquid, large cap market, we explained, is an “open” system where capital flows in and out, distorting prices and spreads. Capital-in” favors issuers; “capital-out” favors investors – all else being equal.
The middle market, and in general, private credit, is a relatively “closed” system. Private credit investors, including middle market asset managers, finance companies, BDCs, and insurance companies, raise vehicles with longer-term investing horizons. Quasi-permanent funding allows managers to patiently deploy capital to smaller companies, insulating them from the vicissitudes of daily market moves.