Focus on covenants, not talk of growth

Private debt has proved it is capable of scaling up quickly, but the key question hanging over the asset class is whether it is also capable of sustainability.

Global asset management is set to see an explosion in growth over the next eight years, increasing from $84.9 trillion last year to $145.4 trillion in 2025, a transformation in which alternative assets, including private credit, will play a starring role.

That’s according to PricewaterhouseCoopers’ Asset and Wealth Management Revolution: Embracing Exponential Change. The report looks at the upside for private debt, an asset class it expects to more than double in size from 2016 to 2025.

This also implies a potential downside, however, as more money continues to be allocated to the asset class and more asset managers decide to get into the private credit game, a move that requires a significant commitment of time and resource.

“Private credit is becoming overheated,” Trent Webster, Florida State Board of Administration’s senior investment officer for strategic investments and private equity, said at the pension fund’s June meeting. “It seems that every private equity fund is raising a private credit fund. We’ve been investing in private credit for well over a decade, so we’ve become more cautious on that.”

That statement served as a harbinger to an observation made during our annual September conference by one long-time industry practitioner: many who have been around the asset class for a long time have become sceptical of it.

What is worth bearing in mind is how limited partners react to private debt and its performance over the long term and not momentary euphoria. Is the asset class fitting into investors’ portfolios and performing as they imagined it would? There is reason to believe the proliferation of covenant-lite loans could be a significant factor in a negative outcome.

The argument for covenant-lite deals, or at least the case made to downplay how egregious some may be, often centres around the terms going to those businesses that are more creditworthy.

Many times, these businesses are larger, often measured by EBITDA, and more diversified. But is the EBITDA metric sound? With so many add-backs and even add-forwards written into deal terms, who’s to say EBITDA definitions are grounded in reality?

Where there are loose covenants, lenders may get to the table too late when a company encounters financial distress, potentially letting value slip away. After all, restructurings, either in-court or out-of-court, all have only a finite pool of resources – one creditor’s gain is another creditor’s loss.

“They’ve put a lot of money into [private credit] managers,” Twin Brook Capital Partners co-founder Trevor Clark told PDI earlier this year, referring to pension funds, endowments and the like. “So, when the new cycle does come, and people get burned, do LPs turn around and say, ‘I knew I didn’t like this asset class’? Or are they going to look back and say, ‘I chose my managers poorly’?”

While many of the brand-name firms have been around since before the global financial crisis, direct lending and other private credit products were an esoteric strategy that had no easy allocation bucket to fit into at the time. Over the past decade-plus, though, limited partners have carved out a space for them in their portfolio and they have become a priority for many.

The exuberance around private credit gives managers reason to believe that it will go the way of private equity, which has raised vast sums of money and holds a record amount of dry powder, rather than the way of hedge funds, which saw large outflows in 2016 and face shrinking portfolio allocations from limited partners.

But private credit’s future is not preordained. Managers that pick bad credits or invest in loans that are essentially structurally deficient may in the next downturn reap the seeds sown during good times, something that could hurt more than just one firm’s cumulative net internal rate of return.

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