This article is sponsored by Arcmont Asset Management
Has the pandemic changed how funds are investing or the types of companies they are lending to?
Generally, most direct lending and senior loan strategies have tended to focus on non-cyclical and growth industries, which have not been as affected by the pandemic as other sectors. However, due to the particular nature of the covid-19 pandemic and the requirement for societal lockdowns and distancing measures, traditionally safer industries have been affected as well, particularly those that are consumer-facing.
Going forward, direct lending and senior loan strategies are very focused on covid-resilient businesses – such as software services, healthcare, education and staple food businesses – which are likely to fare better in the ongoing crisis.
For those higher-return private debt strategies specifically focused on market dislocation opportunities, they will deliberately target businesses that have been somewhat affected by covid-19 but with the resilience to come through the other side.
Are lenders seeing a more favourable environment in terms of pricing and terms?
While we cannot forget the significant health and economic consequences of the crisis, this is one of the most attractive investment environments for private debt I’ve ever seen. It is probably even more favourable than post-global financial crisis, as private debt funds now have significantly more capital to deploy. However, there is quite a wide disparity.
For businesses that are highly affected by the crisis, lending is difficult due to the uncertainty they face in an evolving situation. Nevertheless, for many businesses that have been somewhat affected by the crisis, it is possible to price the risk. In these cases, we are seeing pricing improve by anything from 100 to 300 basis points and leverage levels that are 1x to 3x EBITDA lower than pre-crisis levels. Then there are the covid-resilient businesses, where pricing and terms are similar or in some cases actually worse than they were pre-covid. We see private equity funds paying very high prices and trying to increase leverage, but this can be dangerous as covid is only one risk and does not negate the others.
Regarding terms, there has definitely been a rebalancing towards lenders, but I would certainly not say they are lender-friendly.
Are funds better equipped to take advantage of this than traditional lenders?
Without a doubt, debt funds are in a strong position. Private debt as an asset class really came about from the last financial crisis where banks were very constrained in lending and the liquid markets were very choppy, and it’s a similar situation today.
On the supply side, bank lending for new M&A transactions is very constrained as banks are focused on supporting existing businesses and not making new loans. Research by Oliver Wyman has forecast that there could be between $400 billion and $800 billion of credit losses for European banks due to the crisis, despite government guarantee programmes. This naturally limits banks’ ability to finance new loans to mid-market businesses.
Similarly, the liquid loan and high-yield markets were effectively closed for new issuance from March through to May and have been highly volatile and unpredictable since. By contrast, private debt firms with committed capital offer a lot more certainty to potential borrowers and private equity firms.
Naturally M&A volumes were low during the initial period of the crisis. But European private equity firms have around €200 billion of dry powder that they need to deploy and, as their confidence in the performance of their own portfolios has grown, we have seen a rapid pick-up in deal volumes during Q3, which is continuing into Q4.
How have investors been affected during the crisis?
When the crisis first broke, investors saw a dramatic fall in valuations and found themselves potentially over-exposed to illiquid investments. However, from June onwards, market data shows that those portfolios have seen a dramatic bounceback due to rising public market valuations. In March, some investors paused investment activity, but most have now returned to business as usual.
The attractions of private debt are evident. Low levered senior loans are seen as being very safe in a turbulent economic environment and the premium returns that private debt offers compared with liquid market returns are very significant. I would strongly argue that private debt also offers better protections compared with the liquid markets, which are almost completely cov-lite, whereas private debt is all covenanted.
Importantly, one of the criticisms of private debt has always been that there was not much information on how portfolios would perform in a downturn. We are now in a severe downturn and we are seeing robust performance of portfolios, which is providing further confidence in the asset class.
What are the biggest challenges in communicating with investors?
Investors like to have face-to-face meetings but are getting used to working remotely, and people have rapidly adapted to using technology at a time when meeting in person isn’t possible. According to a recent survey, more than half of investors have said they are happy to do virtual onsite due diligence. However, there is a bias to invest with existing relationships rather than seek out new ones, which plays to the strengths of the more established players.
Has covid impacted private debt portfolios in the short term?
The strong sense I get from private debt managers is that their portfolios have come through the crisis well. There are obviously significant advantages in being in senior debt versus equity as well as having patient capital in locked-up structures, which gives you the benefit of time to deal with any problems.
During the initial stages of the pandemic, lenders and sponsors were addressing immediate liquidity concerns to make sure businesses could survive. In a few cases, this involved equity owners injecting capital and companies accessing government loans where appropriate.
In addressing liquidity issues, we worked with private equity firms, owners and management teams to ensure that portfolio companies had robust structures to deal with extended lockdowns and disruption, in some cases into 2021. As lockdowns were relaxed, many businesses performed significantly better, although it’s clear that further bumps are likely ahead.
In due course, we will need to assess whether businesses can recover or if business models will result in high levels of leverage for a prolonged period. In these cases, a rebalancing of risk discussion will need to be entered into with other stakeholders.
However, there is no doubt that being in senior loans with strong covenants puts you at a significant advantage.
Overall, it appears that private debt portfolios have come through this crisis very well and it speaks to the robustness of the asset class.
What are the long-term prospects for portfolios compared with other forms of credit investment?
The future looks good for private debt. For investors, concerns around performance in a downturn have been addressed and private debt offers significant pricing and structural advantages, including lower volatility, compared with other asset classes.
We are also going to see an opportunity to develop relationships further. We have recently signed deals with private equity sponsors that have never used private debt firms before due to the lack of financing from banks.
If we demonstrate that we can act responsibly and rationally in how we deal with problems, confidence will grow further in private debt being the best source of flexible capital for owners of businesses.