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And the craze goes on

A covenant capping leverage at 9.5x EBITDA that is tripped when the borrower’s revolver is funded to a certain point? That actually happened.

At last week’s PDI New York Forum, a curious sentiment emerged: investors continue to be keen on making room in their portfolios for private credit, while the fund managers themselves are becoming ever-more sceptical about capital deployment.

No one can quite predict how the contradiction will resolve itself, but it appears much more likely that the good times will continue rather than the capital spigots get turned off and deal terms become a little saner.

Despite the concerns voiced by alternative lenders, deals continue to close, and record amounts of capital continues to be raised. PDI’s in-house data show private debt funds raised $119.5 billion through the first three-quarters of the year, which puts general partners on track to surpass the record $130.1 billion raised in 2013.

Meanwhile, covenants get more unfathomable. Case in point: a market source this week highlighted a covenant for a healthcare services company, which had EBITDA in the $75 million-$100 million range, that had a covenant capping leverage at 9.5x EBITDA. The provision would be tripped if the business’s revolving credit facility was funded to a certain point.

In another sign of the times, a second source highlighted a deal involving a golf course developer with approximately $25 million of EBITDA that was structured as a covenant-lite transaction. Additionally, a third source said more mid-market deals are starting to contain provisions with anticipated synergies from an acquisition being added back into the EBITDA before the deal even closes, potentially artificially inflating that metric.

The proliferation of poor covenants may come home to roost, or at least Moody’s predicted so in May.

The ratings agency projected recoveries on recently rated first-lien loans – both with and without maintenance covenants – at slightly more than 60 percent. Compare that with the agency’s 85 percent long-term average recovery for first-lien secured bank debt. Even a traditional covenant package may not be as safe as it once was.

Managers continually tell us there is too much capital chasing too few deals. It’s helpful to attach some numbers to this narrative, at least in the sponsored market, against 2007, with which this year has been often compared.

Financial sponsor-related deal value stood at $494.1 billion across 1,623 deals in the first nine months of 2017, which includes entries, exits and portfolio deals except add-on acquisitions, according to Dealogic. In 2007, financial sponsor-related deal value for the first nine months stood at $783.5 billion across 3,392 deals.

This year has seen far fewer deals at a time when private equity managers, which have raised $377.3 billion through the first three quarters of this year, are on track to raise a comparable amount to the $481.0 billion gathered in 2007, according to data from sister publication Private Equity International.

While private credit dealflow and private equity dealflow are not inextricably linked – there is a growing non-sponsored market for alternative lenders – credit funds often target deals involving a private equity-backed business.

We don’t need another soothsayer when there is one on every corner, but the data and the juxtaposition between investor-manager sentiment don’t portend a good outcome.