Anyone familiar with the private debt world will know baseball analogies are popular, particularly the game of guessing which inning best represents the progress of the benign credit cycle. According to Andrew Konopelski, partner and head of EQT Credit, Europe has moved into the seventh inning of nine, where “maybe things are beginning to look increasingly stretched”. Perhaps the rain clouds on the horizon will stop play.
This measured assessment clearly does not imply things are about to fall off a cliff. Konopelski points out that Europe’s economies have been performing reasonably well and there are indications of further growth ahead – albeit slow growth – in 2019. However, he also makes the striking observation that Europe “likes to hurt itself” when things are going well, as shown by recent political woes in the UK, France and Italy (to name but three) and the trade dispute between the EU and US. At a PDI roundtable in October, Konopelski estimated it would be 18 months before any significant troubles would be encountered, but he now suggests “maybe that timeframe has been brought forward a little”.
This sense that the environment is becoming more unsettled is not necessarily a problem per se. What matters is how private debt firms prepare themselves for what lies ahead. It may mean, in the words of EQT partner Cyril Tergiman, becoming “a bit more conservative” – for example, by favouring relatively less cyclical sectors such as healthcare or TMT and watching portfolio concentration limits closely. But Tergiman, who leads EQT Credit’s special situations activities, also sees opportunity arising from less predictable market circumstances.
Tergiman observes that markets are correcting in value as interest rates go up, monetary policy tightens and risk profiles are reassessed. More companies are beginning to miss their business plans. “From a special situations angle, things are becoming more interesting,” says Tergiman. “It’s been a long time since we’ve seen a market correction and company weakness.”
One of the reasons for below-par company performance is the recent prevalence of EBITDA adjustments, where unrealistic assumptions about revenue gains and cost savings produce overly aggressive debt structures and pricing. “There are a number of examples where EBITDA has been adjusted by 30 percent and it has never translated into reality,” says Konopelski. “People have ended up buying at 10x leverage when they thought they were buying at 7x or 8x and that’s a very different value proposition.”
EBITDA adjustments are a case of reaping what you sow, according to EQT partner Paul Johnson, who says numerous examples were snuck into deal documentation a couple of years ago. It was always likely to be around this point that the seeds sown then would begin to produce a rotten crop.
Johnson, the partner who leads EQT Credit’s direct lending effort, says he hears plenty of talk about tough competition in direct lending, but adds that this is nothing new. “There has always been competition and you have to step away from some deals. There have been situations where we have not been offered the protections we needed, and we have stepped away. You have to have transparency right from the outset.”
Among the mantras that Johnson holds dear is “don’t chase every deal that comes along”. He elaborates: “A lot of firms talk about deal volume, the fact that they see 400 or 500 deals a year. But a lot of that is down to advisors blitzing the market and looking for the most debt for the lowest price and the weakest terms.”
Johnson says the key to success in direct lending is to hone the relationships that lead to repeat business, citing UK education provider Dukes Education as an example of a high-quality and sought-after asset, which the team were able to source based on their reputation for handling similar processes. Pointing to the growth of deals where only funds are approached to provide the debt funding element, Johnson believes it is still possible to avoid the crowds. “Returns are lower than they were two to three years ago but they’re still attractive given the risk you’re taking, especially if it’s a defensive portfolio,” he says.
As conditions become more challenging, Tergiman believes the better managers will emerge from the pack with their reputations enhanced. “When the tide goes out, some ships will get stranded,” he says. “That’s when the good managers will be able to differentiate themselves. The division has already been made, and over the next 12 months we will clearly see the contrast between those who have been disciplined and those who have not.”
One thing is for sure: as fund managers come under increasing scrutiny, investors will be keeping an eagle eye on proceedings. Konopelski says LPs want to know above all that, as funds become larger and larger, they will continue to have the best interests of their backers at heart. “They place a huge amount of trust in their GPs, giving us money for seven to eight years, and want to know that we will look after their interests for that entire time and look to earn the last dollar on the last day.”
With private debt fundraising having peaked in 2017 at $211 billion raised, according to PDI data, investors have become increasingly well-acquainted with the asset class. “The level of sophistication has grown a lot and, at the meetings we have, LPs are now saying, ‘We get private debt, we understand it – just tell me how you’re different’.”
This sophistication unsurprisingly means more forensic analysis from investors. For example: “We have always been asked about the average amount of leverage in our portfolio, but now we’re increasingly having to provide that information on a granular level in relation to each company,” says Johnson.
Tergiman adds that many investors are now seeking to invest across platforms rather than in individual funds. “They get to know you through a fund and then invest in other parts of the platform. They understand that they are getting an entire toolkit.”
He adds that this demands a consistency of approach from the GP across different strategies.
As more LPs invest in private credit, they are also keen to achieve geographic diversification. This has arguably been easier to achieve in other asset classes, though this appears to be gradually changing as the UK’s dominance, especially in direct lending, begins to lessen.
“There is no reason why private debt would not grow into all of Europe,” suggests Johnson. “The banks are always willing to lend and it takes a while for borrowers to accept that they have to pay more for a better solution. But they use it once and it becomes more routine. Of our last five deals, two have been in the Nordics, one in Benelux, one in Germany and one in the UK. The UK may not maintain its historic share as, although it will continue to grow, it will not do so as quickly as the rest of Europe.”
More than minding the gap
While there has been some talk of direct lending peaking, Johnson thinks that it still has a long way to go and that a more challenging macro environment may even provide a helping hand when it comes to growing market share. “Debt funds are not just filling a gap because the banks don’t want to lend,” he insists. “We’re providing solutions that people want and, on some deals, sponsors are now seeing private debt as the best option. Having said that, we’ve all worked at banks and we know strategies can change quickly and they might reduce lending in a downturn.”
But while growing debt fund market share further is certainly seen as achievable, there is an acknowledgement that the overall level of activity would probably decline in a downturn as M&A activity slows and some firms need to concentrate more on issues within their existing portfolios. Konopelski thinks the smaller end of the market may have more issues to sort out: “In the smaller mid-market, say less than €8 million-€10 million of EBITDA, many firms have higher degrees of concentration, whether that is customer, supplier, country. They just have lower resilience, which can leave them more exposed in a downturn.”
Special situations investors would expect to see some interesting opportunities arise from more troubled times. Asked what special situations means to EQT Credit, Tergiman points to “good companies that are undergoing complex situations, but with tangible reasons to exist and where there is a clear path for value to be added. There is often complexity, and there are a bunch of reasons why something might fit in the special situations bucket”.
He adds that EQT’s approach to special situations should not be confused with a focus only on default scenarios. “We focus on corporate risk. The business has to have a reason to exist,” says Tergiman.
“The key thing [in putting together a good special situations deal] is creativity,” adds Konopelski. “You work with the sponsors and the company management to solve whatever problems may exist. You are effectively bailing people out and giving them a runway to achieve their objectives.”
He insists that special situations is a strategy for all market conditions. “It’s a hunter-gatherer business where you have to go out and find idiosyncratic situations. It’s hard to be a purely opportunistic special situations investor, only getting involved when a market is experiencing volatility.” He says EQT has invested €2.5 billion in the strategy, much of it in a benign market environment.
Success or otherwise will come down to whether firms genuinely have the ability to take the reins of a complex business. “The biggest mistake is going long on an asset that is not fundamentally sound,” says Konopelski. “It’s a value trap. There have been a few deals in Europe where people thought they could run the business but couldn’t. People can convince themselves to do things; they’re not always self-critical enough.”
“We spend a lot of time sourcing through our deep network and look for sticky situations,” says Tergiman. “You can own assets for a long time in an illiquid asset class; you can’t just sell out tomorrow.”
Asked what the future brings, the EQT Credit trio reflect on a couple of topics. On the allegedly hot competition in direct lending, Konopelski reflects: “We are at peak numbers in terms of direct lending [managers]. There will be more money but fewer managers in a few years. It’s hard to enter this market now. It’s all about successor funds, and whether you can raise them or not.”
The other big talking point is deal terms, especially the proliferation of covenant-lite. “A lot of it is conjecture as we don’t really know what will happen and how things will play out,” says Johnson.
“There’s no default if you don’t have a covenant, but is there sometimes false confidence when you do have a covenant? It’s a hot topic but it’s not really rampant in direct lending, it’s more in the syndicated market.”
Tergiman points out that the presence of a secondary market for syndicated loans has helped contribute to weaker terms because lenders believe they have the ability to sell if performance issues materialise. In direct lending and special situations, where “you have to own it”, terms are perhaps unsurprisingly more robust.
Furthermore, poor documentation in the syndicated market may provide opportunity for private debt firms going forward. “As a primary investor, you need to back the winners, because you have to live with the consequences of your underwriting,” says Tergiman. “Where there’s inflexible documentation and companies need more capital, funds like ours can be the solution provider for that.”
It may be a late innings, but that does not mean opportunities are drying up. Indeed, for those GPs able to position themselves to take advantage, interesting times could be just around the corner.
Faring well in a choppy market
Wall Street may face a tricky 2019 but direct lenders should still find dealfow opportunities from all the uninvested money sitting in buyout funds. By Andrew Hedlund
If the volatility at the end of 2018 spooked public markets, those active in private equity, dare we say, welcomed it. In 2019, the asset class is looking at further outperformance relative to public markets along with plenty of opportunity to invest its mountain of dry powder.
Private debt continues to be reliant on private equity for dealflow, a trend that a source at an advisory firm says will likely continue this year. And the outlook for private equity is bright in several important aspects. While public equity markets have “been on a tear” in recent years, this source says, the potential for superior returns from private equity, relative to the shares of listed companies, may be attractive to investors.
PitchBook made a similar prediction in its 2019 private equity outlook. While the returns of public and private markets run in tandem in the long run, when rough patches in the economy pop up, private equity returns improve when compared with public markets, even if short-term returns for the asset class fall slightly.
Those private equity firms raising capital for mid-market buyouts may be in a particularly enviable position – almost three-quarters of institutional investors participating in a survey by placement agent Probitas Partners said they would be targeting the sub-strategy. And, of course, that is welcome news for direct lenders.
An eventual downturn this year would, in some ways, be a net positive for private equity firms, and the effects of December’s choppiness have already started to appear in the market.
Valuations have fallen and will likely continue to be in a range much more attractive to buyout shops, causing equity funds to deploy some of the uncalled capital sitting on the sidelines, the advisory source notes. On the credit side of the equation, there was a slowdown in covenant-lite loans in the fourth quarter, one credit manager said, adding that he expected it to continue.
One trade-off for private equity in a bear market, however, could be a fundraising slump. That would be the second year of a fundraising decline for the asset class, which raised a total of $352.3 billion, according to data from sister publication Private Equity International. Last year’s total was a drop of more than one-quarter from the $473.2 billion collected in 2017.
One other potential area where private equity firms might feel a little more pressure is loan documentation and covenants. In an overheated market, sponsors have been able to negotiate terms and definitions in credit agreements that once would have caused alternative lenders to stay awake at night. One credit manager notes there was a slowdown of covenant-lite deals done in December, a trend they expect to continue through the first quarter.
The few drawbacks would seem to largely be outweighed by the positives: increased returns in volatile times could convince investors to increase their allocations, and the dry powder sitting on the sidelines could mitigate any retreat in fundraising.
This article is sponsored by EQT Credit.