There is no doubt that the pandemic has fundamentally dented the outlook for private debt funds in 2020. However, most industry insiders remain optimistic that a bounceback will be fairly painless and that the crisis may even create opportunities.
Sister title Private Equity International’s May 2020 surveys of investors and private equity managers showed fundraising to be getting back on track and investments going full steam ahead, even though portfolio companies were having to make layoffs and grapple with challenges. Nearly two-thirds of investors are eyeing up distressed debt and special situations strategies, which suggests that the form of dislocation we are seeing could buoy credit markets.
Here we look at the big questions that are dominating conversations in the private debt industry.
1. How will deal activity recover?
For managers that need to do deals, and the advisors that support them, this is the question that is front of mind.
Chris Skinner, partner and head of UK debt and capital advisory at Deloitte, says activity has not ceased entirely, but that things are only really likely to start motoring again in Q4. “The debt markets are already starting to recover,” he says. “The focus recently has been on portfolio management, but there is still lot of pressure on debt funds in particular to deploy. We think we could well see some of that pent-up pressure coming to the fore as we start emerging from lockdown.”
Neale Broadhead, European head of private debt at CVC Credit, says: “We have seen evidence of deal activity starting to recover, particularly in mainland Europe. The UK is slightly behind, but there have been positive signs.”
Adrian Chiodo, a partner in the London office of law firm Latham & Watkins, agrees that deals will soon make a return. “This is not like 2008 when there was a liquidity crunch and there really wasn’t money to go around,” he says. “Today the credit markets, and certainly the private debt markets, are much more mature and willing to put money where it’s needed. If you scratch the surface, this still really feels like a temporary blip on the economic landscape, but we just don’t know long it will last.”
Chiodo believes that once momentum starts picking up, which is likely to be after the summer break, deals could quickly return. “The deals happening now are where people think there are good strong assets and the covid impact is minimal,” he says. “I suspect when the restrictions are lifted, the same will continue to apply and people will start putting money wherever they think makes sense. Most people I have spoken to are keen to do deals and will be back in earnest when activity begins to increase.”
2. Does the crisis represent an opportunity in the mid-market?
Most agree that the disruption will benefit strong debt managers, particularly in the mid-market where competition could fall away.
“We see lower pricing, lower leverage and tighter structures benefiting private lenders,” says Keith Williams, managing partner of credit strategies at Crestline Investors. “Some market participants such as BDCs and certain direct lenders are constrained by existing portfolio issues, which means fewer market participants. We expect the big guys to continue to get bigger, thus pushing them to write bigger equity cheques.”
Broadhead says: “Historically, times of uncertainty have also brought opportunity. In the mid-market, borrowers are now seeking alternative financing solutions, as the traditional sources have been retrenching for some time – this will continue to create opportunity for direct lenders.”
“We have seen evidence of deal activity starting to recover, particularly in mainland Europe”
The ability of private debt to provide flexible capital will be particularly attractive. Ramya Tiller, a corporate partner with Debevoise & Plimpton in New York, says: “The covid-19 dislocation will undoubtedly help private debt increase market share because it is very different talking to your relationship lender than going to the syndicated market. Over the last few years, direct lending deals have gotten larger and larger – the actions that direct lending funds take during this crisis will probably contrast with the syndicated lending markets and that is going to work in their favour.”
Jonathan Adler, also a partner at Debevoise, adds: “There really is an opportunity for direct lending funds of all sorts to take advantage of the volatility in the market and provide more flexible solutions. That has been one of the perennial selling points of private debt: they can be more flexible, move more quickly and execute transactions that have a degree of difficulty. That is very attractive in a market such as this one.”
PEI’s Covid-19 Study found 63 percent of LPs had a greater interest in distressed debt and special situations investment strategies.
Williams says: “On the stressed and distressed side, we think things will become more interesting as the longer-term impact moves through the economy and starts to impact good companies with good balance sheets. Then, we will start to see some of the companies that benefited from looser lending practices are going to be overleveraged. We think we will start to see the impact of that in Q4 2020 going into Q1 2021.”
Ainun Ayub, senior vice-president in the alternative fund services business at Brown Brothers Harriman, adds: “We are seeing a new focus on ‘dislocation’ funds. The exact parameters may differ depending on the manager, but they tend to offer a broader mandate than a classic distressed vehicle. Their investment life cycles tend to be shorter – between three and five years – under the assumption that these companies aren’t distressed so much as momentarily dislocated and can recover quicker.”
3. Is this the end for cov-lite?
Skinner thinks it unlikely that deal terms and structures will tighten significantly as the market emerges from lockdown.
“We have now closed a number of deals that started since lockdown,” he says. “When we first started talking to the market about those deals, the initial reaction from managers was that money was going to be expensive, but the reality is that terms have tightened a lot since. All of those deals were by their nature high-quality assets, so one does have to be careful about extrapolating to every deal. But it is fair to say they all closed on terms not too dissimilar from where we were at the height of the market before lockdown.
“The focus recently has been on portfolio management, but there is still lot of pressure on debt funds in particular to deploy”
“Very few of the debt funds were ever doing pure cov-lite, but that was the general direction the market was moving towards. Our sense is that momentum has been pushed back by six months, but as prices in the secondary market start to recover and the syndicated markets start firing back, that pressure will start building on the debt funds again.”
David Allen, founder and chief investment officer at AlbaCore Capital Group, says: “The first lesson from this dislocation is about the responsible use of leverage. In March, when everything went to the same price, this was leverage coming out of the system. The temptation for excessive leverage is clear – when markets are good, it is a quick route to enhance returns. However, over the long term this quick fix is not the most responsible or sustainable mechanism to achieve returns for your investors.”
4. How much support will portfolios need?
PEI’s Covid-19 Study reveals widespread issues in portfolio companies, with 60 percent of managers saying layoffs have been made since the start of the pandemic and 49 percent saying layoffs are planned. Skinner says: “The reality is that plenty of deals done over the last 24 months will now look very aggressive. There are a lot of lenders with high levels of discretionary spend-related assets in their portfolios, and that is a challenging backdrop for new deals to come to market. That said, those same funds are going to see opportunities for very high-quality deals, even while some will be grappling with their own problems.”
Ayub agrees that portfolios are going to need a lot of support, but says private debt managers are well-placed to respond to issues.
“Private debt managers tend to be smaller organisations so they can be more vulnerable than big banks with huge diversified loan books, and credit teams backed by substantial operational and compliance resources,” he says. “But these smaller players can also use their size as an advantage. This isn’t to say that the analysts at a large bank aren’t close to the ground as well, but private debt managers, by their very nature of managing fewer investments, are going to understand their borrowers more intimately. That creates unique perspectives that might be missed by banks operating with a more assembly-line approach. Being so up close, managers can customise solutions that take into consideration where a borrower is, and where they may be headed in the wake of covid-19.”
Chiodo says this is already evident: “What is indicative of perhaps an upside of private debt is that funds are working with the borrowers and the sponsors to find solutions. Even if companies are struggling, we aren’t often hearing about it publicly. This shows the system is working well behind the scenes.”
5. Can deals really get done virtually?
Managers are getting used to new ways of working and a lot of activity has moved online pretty seamlessly. Yet although deals are getting done ‘virtually’, activity looks set to ramp up significantly once meetings can be done in person.
Williams says: “From a sourcing perspective, we initially focused on those investments where we met the management team pre-covid-19 or companies or individuals we have worked with before. We have yet to close a new deal with a company where we have not met the management team in person, but we do have multiple term sheets signed with those types of situations. We would like to see them, whether we travel to see them or they would like to come see us. Regardless of the venue, we will obviously take all the appropriate precautions.
“Most people I have spoken to are keen to do deals and will be
back in earnest when activity begins to increase”
Latham & Watkins
“We still feel it is essential to meet a management team in person before doing a deal, but an alternative is that we could ask one of our third-party connections to do that element of the due diligence for us.”
Broadhead at CVC says: “A trend that had begun pre-covid crisis, but has greatly accelerated in recent months, is management interaction. We have been pleased to have been able to constructively interact with sponsors and management teams via multi-media engagement and from a portfolio perspective it has enhanced frequency and quality of interaction.
“This has helped build rapport with management teams at a time when we are seeking greater contact than is required by documentation. We expect to continue to use all the tools at our disposal – even post-covid.”
Chiodo thinks the lifting of restrictions will directly impact dealflow: “It will be interesting to see what happens when we get the green light to go back to work. As soon as investors can meet management teams face-to-face, I think people will start doing deals and we will quickly get back to the dealflow before lockdown. In this industry, if it’s a fresh deal, there is still a strong preference to want to meet management face-to-face.”
6. Is portfolio financing set for a boom?
Some 37 percent of investors are receiving requests from fund managers for expanded use of fund-level credit, and many in the market report an increase in the use of NAV lines, which enable GPs to take loans secured against the value of a portfolio.
Crestline’s fund liquidity solutions group is busy, says Williams: “At a time when private equity funds are having to put capital into deals that they maybe would not have had to support otherwise, portfolio finance is an area where we are seeing a lot of opportunity. There are funds that are maybe seven to 10 years old, with fewer healthy assets remaining, and those assets need funds to see them through covid-19. Those managers are looking at loans secured against remaining NAV to support those companies, in preference to going back to LPs.”
Tiller at Debevoise says managers are spending a growing amount of time focused on their own borrowings. “Those facilities have become much more common,” she says. “Debt funds often have NAV facilities secured by the credit investments that the fund has made, borrowing against the value of their investments. As underlying values become distressed, however, they can no longer borrow against those assets in the same way, and the amount available becomes constrained. We are seeing credit funds talking to their lenders about managing their portfolios and managing their own loans.”
7. Will LPs start making additional demands?
The fundraising market remains good for private debt and most LPs report a good level of visibility over the impact of covid on portfolio performance. Market participants say GPs are generally being proactive in keeping their investors well informed, without the need for enhanced legal obligations.
Adler says: “We have not seen any movement in the shape of market terms [on GP/LP relationships] since this began. But it is not business as usual. There has been a real increase in the pace and granularity of communications between sponsors and investors on the status of existing portfolios, to an extent not seen in normal times. That is not because LPs are demanding that in side letters or anything, but some GPs are holding monthly calls and making an effort to keep investors in the loop. That is a shift and is likely to continue for some time. It shows the flexibility in fund agreements, which don’t necessarily dictate every aspect of operations, but information sharing has happened when it was needed.”