‘They’re not just taking our lunch but our dinner as well.” This was what a source in the market was told by a leveraged financier at a bank who was pondering the growing evidence that private debt firms – in the process of doing ever-larger deals – are moving once again into areas of activity considered the traditional preserve of banks.

The banks have been successfully challenged by private debt before of course, ceding to them a large chunk of corporate mid-market lending in the years following the global financial crisis. Up until recently, they had not thought it likely that the uppity newcomers would be a threat to their established business of arranging and syndicating large-cap deals. But with news that private debt firms are muscling into large corporate financings like the one for UK pharmacy chain Boots, the banks are now alive to the issue. Whether they can do anything about it is another matter entirely.

Annette Kurdian, a partner specialising in leveraged finance at law firm Allen & Overy, traces private debt firms’ first serious steps into the larger deal market back to 2014/15, when the public markets got more expensive, and some of the benefits of the private debt option – including speed of execution, certainty of capital and the absence of market flex – began to be widely acknowledged. But it was the global pandemic that, in her view, effectively secured the trust of sponsors.

“They behaved well and supported companies through difficult times,” says Kurdian. “In bank-syndicated deals you often find people trading out, and clients are lost. But private debt was seen to be sticking with the assets. This made sponsors happier to do deals with private debt.”

The current popularity of the private debt option is also connected to the volatility in the markets prompted by soaring inflation, the prospect of interest rate hikes and the geopolitical tremors associated with the conflict in Ukraine. “There’s currently dislocation in the public markets and no certainty that you’ll have bank finance in place when you need it to complete the deal,” says Faisal Ramzan, a partner and member of the private credit group at law firm Proskauer. “Private debt funds have committed capital and therefore the ability to deliver whenever the deal needs to close.”

Ramzan also points to private debt’s flexibility and sophistication as an attractive feature for sponsors and borrowers.

“With Boots, the amount of capital – and the level of financing sophistication required – means that banks wouldn’t necessarily be able to deliver the whole package themselves. For deals like this you may need additional leverage through a private capital solution like preferred equity or a PIK [payment-in-kind] instrument, and only private debt can do it.”

Making a mark

Beyond Boots, there are plenty of other deals where private debt has made its mark at the larger end of the market. Currently in the headlines is a reported $4.5 billion unitranche financing being led by Blackstone in support of private equity firm Hellman & Friedman’s purchase of IRI, the market research firm. There have been many other weighty unitranche deals undertaken by private debt firms in recent years, including a $3.4 billion facility for Galway Insurance in the second half of 2021, led by Antares Capital.

Ben Davis, a partner and colleague of Ramzan’s in the private credit group, notes that, of the 81 private debt deals Proskauer advised on in Europe last year, more than 10 percent featured debt facilities worth more than €500 million.

Xenia Sarri, managing director in the capital advisory group at investment bank Lincoln International, says there are a number of reasons why private debt is increasingly favoured by borrowers wanting large financing packages. One is avoiding flex risk. “If the market moves by the time a deal goes to syndication, the pricing might need to widen in order to clear. In that situation, you may end up with a higher-yielding debt than when the loan was underwritten, and potentially a tainted deal. From a reputational point of view, as well as predictability of cost, you may well be better off taking the private credit solution.”

Although there is a premium associated with private debt financing, Sarri thinks it’s not necessarily the case that it’s more expensive in the round. After all, a syndicated deal can involve obtaining a rating and managing a number of different banks, which can add up to a costly process.

Aude Doyen, head of UK debt advisory at Lincoln International, adds that the relationship aspect is an important consideration too. Given the fact that many mid-sized businesses and their private equity sponsors have grown accustomed to working with private debt firms, what would be the logic in jettisoning those partnerships as the businesses grow? “You have a debt fund that you’re familiar with and can support you going forward,” posits Doyen. “Why would you swap that situation for the syndicated market and more risk? You might make some savings, but not much. We see sponsors and borrowers think twice before moving away from relationship lending.”

Then there’s the issue of privacy given that private markets are, well, private. “It’s a competitive market and sponsors generally prefer less public disclosure, which is why historically they’ve shied away from the high-yield bond market,” says Sarri. “In the syndicated loan market there’s less disclosure than in the high-yield market but there’s still a lot of information that needs to be shared with multiple market participants.”

Given the many factors apparently in their favour, are private debt funds set to conquer the larger end of the market?

They’re certainly making themselves a force to be reckoned with, but there are constraining factors. One is concentration risk, with many managers committing to invest no more than a certain amount (often 5-10 percent) of the fund’s total capital in one deal. However, funds effectively looking to adopt the bank syndication role are at liberty to take a substantially larger amount onto their books in the first instance with a view to selling down a large slice of it.

Sarri relates the case of a large deal in the Nordics where two lenders offered to take the entire financing amount of around €300 million onto their books. “They said they were confident that they could retain around a third of the total and get the rest off their books. In order to win the deal, they were happy putting up 100 percent.”

Hung syndications

But are fund managers really comfortable becoming fully-fledged syndicators? Trevor Castledine, a senior director at consultancy bfinance, suggests the potential drawbacks of this should not be underestimated: “If you underwrite deals in the hope of being able to syndicate and then the music stops, history shows that you can end up with hung syndications and with positions that may breach your concentration risk limits. It would also get in the way of writing more business, as the capital is tied up and you have less to invest.

“If you’re effectively becoming a bank you have to accept that involves more risk and you need to make it clear to your investors that these risks exist and that you may need to sell positions at a discount.”

The flipside to this is that limited partners may have something material to gain from syndication beyond just having exposure to large deals in the fund. “Sometimes a credit fund may sell down a piece of debt directly to its own LPs outside of the fund arrangement, so that LP has more skin in the game,” says Ramzan. “It’s a kind of ‘double dip’ that’s favoured by some investors, such as LPs and fund managers.”

Another consideration for private debt funds dabbling in larger deals, if not exactly a constraint, is how investors might respond to any attempt to weaken terms and conditions. In the mid-market, many deals still feature at least one or two covenants. In the broadly syndicated market, such protections are almost entirely absent. Will private debt firms prioritise winning the deal regardless of how much investor protection they cede, or will they hug their investors close, to the potential detriment of borrowers and sponsors?

Castledine of bfinance is not instinctively opposed to lenders migrating to ever-larger deals, making the point that there may be less competition from other managers. However, he also acknowledges the challenge of taking on new and different sources of competition. “Essentially, you could end up competing for deals with markets which don’t require strong investor protections such as covenants,” he says. “Your focus will need to be on maintaining discipline over terms and conditions. Even if you do retain covenants, do they still bite at the same level as in the mid-market?

Kurdian says: “Funds are doing deals on the basis of terms and conditions that they never would have contemplated two or three years ago. But they’re doing it because they have to give borrowers the same flexibility that they can get from the syndicated market.”

She makes the point that while this is not necessarily the preferred approach to a fund and its investors, funds will take a good credit with more flexible terms over a bad credit with tighter terms, and that even deals with “financial covenants may not mean much anyway – given the headroom and adjustments, it can just be a box-ticking exercise that doesn’t give you a meaningful early warning system”.

Ramzan points out that some fund managers have an agreement with their investors – whether formal or informal – that they will not invest in covenant-lite deals. But he adds that this can sometimes be circumvented by a bespoke arrangement, such as a side pocket, for investors willing to commit capital on that basis.

Watch out for the regulators

Regulation may be another constraining factor. If a fund manager to all intents and purposes looks and behaves like a bank, chances are it will be treated by the regulators as a bank. But while moving into the syndication market undoubtedly carries the risk of greater scrutiny, Sarri believes that equal treatment is unlikely given the banks’ strong retail component versus the sophistication of the private debt investor base.

“What’s at risk is very sophisticated LP money and governments are less inclined to regulate to protect those investors at the same level as they would depositors,” she says. “Will there be more regulation as the asset class gets bigger and bigger? Probably. But will there be the same kind of regulation as for the banks, given who you’re trying to protect? I think it’s unlikely.”

Although there are constraints for private debt funds, those affecting the banks are arguably even greater. Because of the high risk-weighting, they are unable to sit on large underwrites for very long – possibly only for a couple of weeks. There’s also the substantial cost of obtaining ratings, which private debt funds don’t necessarily need to do, and – as mentioned previously – the issue of market flex.

Some believe that – as has sometimes been seen in the mid-market – banks will look to partner with private debt firms by applying the old principle “if you can’t beat them, join them”. Back in 2017, for example, London-based manager Park Square Capital signed a direct lending joint venture with SMBC, while Ares Management and GE Capital had a similar relationship dating as far back as 2012. It would be no surprise to see further such arrangements going forward – albeit targeting larger deals and with larger chunks of capital

Such moves may to an extent mitigate the banks’ sense of loss. Nonetheless, it’s hard to avoid the conclusion that, as the ambitions of private debt firms rise in line with the size of their fundraising achievements, the traditional syndicators of the larger deals may be bracing themselves for another big loss of market share.

Super-sized five 

A handful of the outsized private debt facilities that have been grabbing the headlines

1: The Ardonagh Group
In June 2020, Ares Management announced it was serving as lead arranger for the £1.9 billion ($2.4 billion; €2.2 billion) financing of the UK’s largest independent insurance broker. Ardonagh was majority-owned by HPS Investment Partners and Madison Dearborn Partners. HPS was also one of lenders on the deal, alongside CDPQ and KKR.

2: Calypso Technology
In April 2021, Owl Rock Capital’s $2.3 billion unitranche financing for the buyout of Calypso Technology was a record at the time for the US market. The financing backed Thoma Bravo’s acquisition of the provider of cloud services and blockchain technology to the financial services sector.

3: Galway Insurance
A new size record was set in October 2021, with insurance distribution firm Galway receiving $3.4 billion of debt financing in a deal led by Antares Capital. Ares Management, Golub Capital, KKR and HPS acted as lead arrangers and bookrunners on the deal, which featured a unitranche, a delayed-draw term loan and a revolver.

4: Inovalon Holdings
A $2.84 billion unitranche facility supported the take-private of Inovalon, a provider of cloud-based platforms for data-driven healthcare, in the final weeks of last year. A major part of the debt financing package was provided by Blackstone in a deal that was led on the private equity side by Nordic Capital.

5: Stamps.com
The $6.6 billion acquisition of Stamps.com, the mailing and shipping business, by Thoma Bravo in July 2021 featured a $2.6 billion debt financing facility including Ares Management, Blackstone, PSP Investments and Thoma Bravo’s own lending arm.