The transition from 2019 to 2020 was already transformational for private credit funds using leverage facilities to finance their portfolios. Something that only a few years ago sounded so specialised (leverage facilities for private credit) was now uselessly generic.
Private credit could mean anything. Maybe your firm manages business development companies or mid-market collateralised loan obligations. Maybe you have long-term sources of capital, or you invest in commingled funds or annual series of separately managed accounts. Your private credit platform may favour non-traditional asset-based loans, mid-market direct lending, cashflow-based unitranche, litigation finance or consumer/fintech strategies.
As managers have focused their strategies, leverage solutions for portfolios have narrowed. It is no longer as simple as calling a few of the dozen or so private credit portfolio lenders.
As private credit managers developed their specialities, and as their investors made allocation decisions to specific sub-strategies, portfolio lenders kept pace. Fully understanding the underlying collateral and method of repayment is as much their raison d’être as yours. Whether you are an industry ‘blue blood’, or deeply focused on one of the many new credit products, chances are that you are in the market for portfolio-level leverage provided by a bank, insurance company or other type of investor. For most fund sponsors, the asset class’s expansion has made obtaining an efficient leverage facility all the more challenging.
Trepidation and reassurance
However, as Mike Tyson famously said: “Everybody has a plan until they get punched in the mouth.” Private credit fund sponsors, investors and their financing partners devoted much of 2020 trying to make sense of covid-19’s impact on their underlying investment portfolios, dealflow, investor resiliency and the availability of leverage for their funds’ assets. Just as businesses looked to their lenders with trepidation and eager reassurance, private credit fund managers looked to their portfolio financing sources in much the same way.
Before long, borrowing base deficiencies, margin calls, net asset value covenant triggers and other markers of distress began to arise. There were ‘canaries in the coal mine’ (BDCs in their publicly available financial statements and CLOs with well-documented overcollateralisation test failures). By the summer, it was understood that private credit fund leverage facilities were being subjected to their greatest distress since the global financial crisis.
The importance of planning is demonstrated not by validation of those who predict the future, but by the adaptability of those who did not. Adaptability is not a globally ubiquitous trait. Although dialogue between private credit managers and their portfolio lenders increased in both frequency and candour, those conversations and enhanced data exchanges showed not all private credit portfolios were both varyingly resilient and jeopardised by the economic deterioration.
“At worst, there will be credit fund managers mismatching their financing to their assets”
Fund Finance Partners
During the first half of 2020, lenders to private credit funds that identified events of default were forced to accommodate these funds, whether in the form of waivers or amendments, or cut bait and either accelerate outstanding amounts due or withdraw lines of credit to certain fund sponsors.
The impact on certain BDCs, for example, led to a reinvigoration of the M&A market and rumours of changes of control. Others were left in precarious liquidity situations, forced to sell valuable assets or forego attractive lending opportunities. More fortunate private credit managers saw their lenders extend generous covenant accommodations.
Those private credit fund sponsors deemed worthy by their lenders benefited from amendments to their leverage facilities. These resulted in temporary expansions of borrowing base capacity; amendments to certain coverage and concentration ratios (subject to expiration); NAV and tangible net worth covenant holidays; and temporary restrictions on distributions in exchange for some pricing and perhaps enhancement of mandatory prepayments upon certain liquidity events. Although the menu for ‘favoured’ private credit fund platforms included a combination of leverage holidays and prepayment obligations, the ability to obtain such accommodations has spoken volumes of the private credit ecosystem of lenders, investors and counterparties.
As portfolio distress abates, specialisation, which dominated private credit lender finance until covid’s rude interruption, has retaken the floor. Successful private credit fund sponsors are seeking leverage for portfolios of loans that might have been financed by certain lenders in the late 2010s but may no longer be suitable for the same leverage provider. Capable credit fund sponsors whose incumbent leverage providers have left, and successful credit managers that are only now leveraging their funds’ investments, are looking for new lending relationships.
Many quality private credit fund managers are striking out for fund-level leverage for the first time, either due to a history of non-leveraged investment strategies or as part of emerging platforms. Many first-time leverage seekers presume their subscription facility provider will naturally be a source of portfolio leverage. The credit criteria, pricing, risk assessment and strategic use of bank capital for subscription lines and asset-level leverage lines are drastically different. Notwithstanding the efficacy of subscription and, increasingly, hybrid lines for ramping private credit fund assets as closings take place, it is certainly not a foregone conclusion that a fund’s subscription credit facility lender will even be interested – much less the ideal lender for asset-level leverage.
Some of the largest money centre banks, as well as smaller regional institutions, speak for a healthy share of the credit fund subscription market. Yet when it comes to asset-level leverage, many money centre banks have minimum facility size requirements. They may also be more inclined to extend credit to platforms doing a meaningful amount of other fee-generating business already. On the other hand, there are smaller, regional banks providing subscription lines to pre-eminent, established credit platforms that are uninterested in
asset-level leverage products.
Discerning lender interest in subscription lines from lender interest in NAV, or asset-level leverage, is only the start. Once you’ve listed the banks providing leverage to credit fund portfolios, the analysis becomes more nuanced, as certain banks have collateral-level EBITDA thresholds, biases among bilateral, club and syndicated loans, preferences for collateralised or cashflow-based loans to sponsored borrowers and minimum transaction
Private credit platforms forced to reconsider their lending relationships, or newcomers seeking leverage, can spend an inordinate amount of time and resources sifting through the options. Many will settle for sub-optimal credit lines or financing sources due to their relative limitations. At worst, there will be credit fund managers mismatching their financing to their assets. This is why thought leaders are devoting so much time to the topic, and managers are seeking specialist advice in connection with their leverage strategies.
As unique as your credit investment strategy is, and as bespoke as your investment vehicle may be, the leverage provider that was eager to do business in 2015 may no longer be able to. Even though you may be faced with an odyssey in obtaining asset-level leverage, the innovation and specialisation that have taken place among the lender finance community, and the battle scars earned by portfolio lenders and credit fund managers in 2020, have forged a cohort of private credit portfolio financing partners eager to prove their thesis. Notice the increase in complexity, but seize the opportunity from all the new sources of credit fund financing.
Some of the private credit sponsors who navigated 2020 have offered the following insights to their lenders for 2021
1. Consolidate your offerings: Private credit clients that have emerged in a position of strength are seeking comprehensive product offerings (ie, relationships). Credit fund sponsors are seeking lending relationships with institutions that offer the comprehensive suite of lender finance solutions: subscription lines; umbrella subscription line solutions; asset-based facilities (whether that means total return swaps, mid-market credit fund facilities or NAV-underwritten facilities); hybrid facilities (that actually give credit for performing loan portfolios, as opposed to labelling a subscription line a ‘hybrid’ and taking a lien in the portfolio); and securitisation solutions for mid-market CLOs, broadly syndicated loan portfolios and multi-tranche loan funds.
2. Come to the party, earlier: Private credit fund borrowers – whether SMAs, commingled funds, JVs or off-balance-sheet arrangements – are looking for constructive leverage earlier than lenders are offering. This has been the case since the advent of private credit. The difference for most managers now is that positions in new vehicle-borrower portfolios are either in other lender-financed and lender-underwritten portfolios or possibly leveraged by a fellow lender finance cohort in another format. If a prospective borrower has a portfolio of loans that a bank has already advanced against, or if there are co-investors in those loans that are also borrowing from the same financial institution, credit fund manager-borrowers are less understanding when their financing request goes unanswered. Credit fund managers do not expect a perfect overlap, but the disconnect that persists while portfolios ramp is not ideal.
3. For ‘in the box’ cashflow-based, senior secured credit fund managers, there is a bifurcation of the portfolio finance market between ‘in the box’ upfront advance rates based on certain eligibility criteria and ‘lender approval’ types of facilities in which assets are not leverageable until the asset-level lender approves them. It has long been conventional wisdom that there is a marginal benefit to ‘in the box’ rather than ‘approval right’ facilities due to the autonomy offered to credit fund managers. In 2020 and into 2021, the direct lending/mid-market credit investment community has been consistently ambivalent between ‘in the box’ and ‘approval right’ facilities. In fact, there is a presupposition among fund sponsors that ‘approval right’ facilities may accompany marginally better borrowing terms, given the shifting of credit risk analysis from the fund lender to the bank lender.