This article is sponsored by Fiera Private Debt
For private debt managers, it is the good times – such as the current, long economic expansion – where competition for deals really heats up. As this expansion has been so volatile and uncertain, LPs have made plenty of commitments to private debt funds. This in turn has left managers with war chests, but without the opportunities to match.
According to Preqin’s 2018 Private Debt Report, there was a record $309 billion in dry powder as of June last year and 53 percent of managers said competition for deals was the biggest challenge they faced. We spoke to Philip Robson, corporate and infrastructure debt financing executive vice-president at Fiera Private Debt, and Theresa Shutt, the firm’s chief investment officer, about the market and their philosophy for weathering the good times.
Is there too much money in private debt markets now?
Philip Robson: The question isn’t whether there’s too much; it’s how those commitments are deployed. There’s been spectacular growth over the last few years of allocations to both private debt and private equity.
GPs that might have raised $300 million-$400 million a few years ago are raising a billion or more now. With that kind of money, there’s more pressure to deploy and to do so more quickly. This can make it too easy to yield to the temptation to loosen standards or to allow style to drift.
Theresa Shutt: LPs have become more aware of the increasing levels of dry powder and the growing competition. One of their biggest concerns is that their managers may be taking more risk in order to deploy capital and accepting more covenant-lite loan structures, particularly in the sponsor-backed market. In some cases, managers may be getting pushed into loans that have very minimal covenants or no covenants at all.
To justify cov-lite deals, managers may attempt to assure LPs that a particular company is so strong that covenants are not required. Investors are savvy enough with private debt as an asset class to be anxious about these kinds of responses.
I read recently that acquisition multiples for PE-backed leveraged buyouts are averaging 10x EBITDA, which is historically quite high. That typically means higher leverage in the debt world as well. While our maximum threshold for leverage across our strategies is 4.5x, we’ve been increasingly hearing about leveraged buyouts being done at 6-7x total debt to EBITDA, which is nearing 2007 levels.
We frequently get asked about leverage ratios for the underlying loans in our portfolios, and investors are digging deeper into what is actually senior secured. There’s been this move towards unitranche structures in private debt, where the LPs may think they’re getting mostly senior secured debt investments, only to look closer and discover quite a few slices of mezzanine debt.
Given those tendencies, how are LPs handling manager selection?
PR: When we raised our first fund in 2004, it was really a ‘trust us’ argument which, to be brutally honest, was more about luck. Now, LPs are looking more closely at the tenure of the managers, and by that I don’t necessarily mean the tenure of a specific fund.
LPs and their consultants are looking much more closely at the experience and capabilities of the people inside the manager. What is their experience with finding loans? Or fixing them when there are problems and protecting their capital?
In our world, a lot of LPs are closed, defined-benefit plans. That means the capital is locked and there aren’t 5,000 workers out there still making contributions. Capital lost through a broken private debt investment is lost for good. So, they’re asking about the process, the controls, the internal governance structure that ensures the firm doesn’t drift from its mandate, and at a manager’s track record in working to minimise downside risk and recover LP capital.
TS: Five years ago, investors used to focus on the net return number, because theywere highly focused on fees. Now they have significantly more experience and are asking the right questions about debt seniority and leverage.
Before making an investment in our funds, LPs will spend significant time evaluating our underwriting process. They will come in for an on-site visit and will want to understand why a particular investment met our criteria. They want to know our thinking and be comfortable with our analytical ability and experience with different industries.
We like to stress with LPs that we don’t do covenant-lite loans. We strongly believe that covenants are critical as they enable us to track the performance of the business and provide early warning signs of potential problems. Covenants also provide us with the ability to intervene in the business to ensure a better outcome.
While financial covenants are important to track performance, we also structure what we call ‘moral hazard’ covenants to ensure tighter controls over our investments. These are covenants that prevent borrower management from taking certain actions that could be detrimental to the business and to our position as a lender. These covenants can restrict distributions and asset sales and prevent the borrowers from changing the nature of the business.
These covenants don’t exist in big deals and that’s concerning. I was on a panel recently and a fellow panellist shared an anecdote about PE firms that insist their lenders use their lawyers to structure the credit agreements. As a lender I can’t imagine not having our own counsel during the negotiation to protect our interests as a creditor.
“Covenants are critical as they enable us to track the performance of the business and provide early warning signs of potential problems”
So many private equity firms have launched their own private debt funds. How has that shaped the industry you operate in today?
TS: We’re going to have to look at their performance over the long term. Fundamentally, our belief is that an equity investor thinks differently to a debt investor, and that’s really important. Their experience is all about the upside and growth and what they can sell the business for later. For a lender, it’s all about the downside. We do look at EBITDA growth to determine whether the company can generate sufficient and sustainable cashflow to service the debt, but we spend a significant portion of our credit analysis reviewing worst-case scenarios.
Credit isn’t rocket science, but 30 years of credit experience can’t be replicated. A lot of our LPs want to do direct investing but the ones that have tried it learn quickly that it’s a specialised skill set and that it’s difficult, requiring a very different mindset than making a private equity investment.
PR: There is a growing conversation about LPs wanting to partner directly with private debt investors. A large enough pension plan or institutional investor can afford the costs and time required to build out a 15-person debt team to start acting like a co-investor or a partner in the private debt space. In Canada, I can count the number of players that size on my fingers and toes and as a group they tend to be shrinking as closed DB plans are increasingly in deaccumulation mode.
I worry about this trend because that big pension plan has to write a big cheque to co-invest at a level that will move its return needle. The size of that commitment could potentially have a negative impact on its overall private debt diversification and it might not appreciate the full risks involved.
Our last fundraise was north of $800 million, but our average investment is still sub-$20 million, and that’s diversification which works in our investors’ favour and protects our own balance sheet. I fret about LPs chasing yield and losing sight of the fact that they don’t have the expertise that comes from being beaten up year after year in the lending business.
Where do you see the private debt market, as a whole, heading in the next year or so?
PR: It’s been long enough into this expansion that I’m getting worried. A lot of the timeless standards are still relevant. Having done more than $4 billion in private debt investing as a firm, while only having written off $5.6 million, we know the old ‘Cs’ matter most in this business: the character of the borrower, the cashflow, the collateral and the capacity to pay. No matter how much money gets raised or what players venture into this space, the winners will understand those four factors.