Many in the private debt space point to the retrenchment of banks from the mid-market as the reason for the asset class’s near-exponential growth, something many in the industry believe to be a secular change due to financial regulatory policy and higher capital requirements.
However, as it grows up, another factor could also help drive the expansion of the private debt market. Beyond investors searching for higher return rates with a reasonable downside risk, more borrower-friendly terms could also fuel the asset class’s growth. Sources have told PDI that sponsors have been getting more favourable financing recently.
One example a source relayed to PDI includes sponsors seeking a longer timeframe over which earnings before interest, taxes, depreciation and amortisation (EBITDA) can be applied to certain covenants.
In financing used for acquisitions, sponsors are now looking for a longer time window for the target company’s EBITDA to put toward incurrence covenants, which would make it easier to service debt lower in the capital structure or make dividend payments.
Sponsor-backed mid-market lending in the US has more than enough room to grow as well, according to a Paul Hastings credit market outlook. It stood at a low level in the second quarter of this year, at just over $5 billion after reaching more than $15 billion in the fourth quarter of 2012.
The relaxed covenants make the target company’s shareholders and junior creditors happier, of course. Another factor may also be working in their favour as well. One attorney sees intercreditor terms becoming favourable to those lower in the capital stack.
“Because of the private nature, the illiquid nature of the instrument, we’ve had a lot of success pulling those terms up market,” Bill Brady, a partner at Paul Hastings, said at PDI’s US Roundtable event in July. “They’ve never been there before in any meaningful way. It really is a new frontier for these new more junior [creditor]-friendly intercreditor provisions.”
Mid-market alternative lenders, Brady said, have “started writing bigger cheques” or “club it up with four or five lenders,” and, as a result, pulled those intercreditor standards benefitting more junior lenders into the larger deals.
As we have moved to a later stage in this credit cycle, more private debt managers have said they prefer first lien or senior secured investments. The Paul Hastings report showed the volume of second lien facilities, both syndicated and privately placed, standing at $510 million, down from $1 billion in the first quarter. The more senior debt mitigates some downside risk, as the lenders would then be among the first in line to get repaid should a borrower encounter financial distress.
Whether lenders, as a whole, may become more hawkish on their lending standards, and whether sponsors may accept less-friendly borrowing terms as the credit cycle wears on, remains an open question. But with more LPs creating separate investment categories for private debt, there is little doubt the capital will be there and the potential remains for sponsor-backed activity to grow in the second half of the year.