5 questions LPs in debt funds must ask about deal structuring

With corporate debt levels coming under scrutiny and worries of a global slowdown growing, private debt investors need to know where to look for risks.

Corporate debt levels have come under scrutiny in recent months. Leveraged loans have grown significantly and some question whether the risks are fully understood.

With $1.3 trillion worth of debt outstanding on those loans, almost any private equity-led transaction is likely to include leveraged debt in its makeup. The leverage market provides support to rapidly growing businesses and has itself expanded rapidly.

How should limited partners react to this scrutiny? Here are five questions they should be asking about the structure of a private debt fund.

  1. Who’s leveraging what?

Leveraged loans have their place in the debt markets. However, there has been a trend towards offering debt to businesses at ever-increasing debt multiples. If global growth starts to slow, this is where stressed structures could be seen first. Fund managers should be considering the overall debt within capital structures in any given transaction where their funds can be deployed – and be considered in their attitude to risk.

  1. What covenants are in place to mitigate risk?

LPs should consider the amount of risk the sponsor is taking and the risk being transferred to debt when structuring deals. Cov-lite leveraged deals have fewer protections for investors than traditional structured loans. Indeed, some are using cov-lite loans to pay off more structured debt, replacing less expensive, more structured debt with another, more expensive, but looser debt structure. This does materially increase the risk profile of the debt, but it is still dependent on the same underlying business for repayment. Ultimately this does provide the company with the debt greater flexibility in the event of more uncertain trading, which can give companies the ability to be flexible and trade through economic cycles.

  1. What levers can your fund manager pull?

With leveraged deals, financial burden increases as uncertainty does. It can be hard to determine where the equity of a company actually is and what it is worth. Debt for equity swaps in restructuring deals put higher levels of stress on investors, too. Getting to grips with the true value of the equity in play and how highly-leveraged debt may be converted to equity is critical in minimising losses on defaults.

  1. How does structure affect returns?

The nature of private equity investment often means investing in a new structure for a company, and that can affect returns with private equity targeting a multiple of its investment. Debt funds are built to deliver a comparatively modest yield, so if a debt fund underperforms, the yield will reduce and this impacts dividend returns and may lead to the capital not being fully returned to investors.

  1. Where’s the senior debt?

Much has been written about leverage loans and their creditworthiness. Banks still have a critical role to play in underpinning dealmaking. Super senior and senior debt offer safeguards through more highly structured debt and therefore increased stability. Yes, the multiples might be lower, but the structure of the debt and liquidity of banks often enables any companies that do experience stress to have more time to trade back up.

Scott McClurg is head of Middle Market Financial Sponsors, HSBC UKprivate