What the future may hold for lenders

Strong US GDP growth in 2018 was sustained as retaliatory tariffs by China failed to significantly impact exporters. President Trump and the European Union came to a new arrangement on tariffs, seen as vital ahead of European elections and the UK’s departure from the bloc, which mitigated the immediate economic effects of the trade war.

However, this strong growth, and new tariffs for previously cheap Chinese goods, began to once again stoke the fires of inflation, something most US consumers have been untroubled by in recent decades. Increased production of raw materials in the US came at a cost as unions began to demand a share of the wealth being generated.

Faced with the potential for inflation to creep above 3 percent, the Federal Reserve increased interest rates to 2.5 percent in November 2018 and made a further rise to 3 percent in March 2019, nine months earlier than most analysts expected in mid-2018.

While most private debt instruments were based on floating point rates, the initial impact on the private debt industry was largely positive with returns to investors benefitting from the additional premium. However, the summer months saw some private equity-backed leveraged buyout targets begin to struggle. Some firms were lumbered with very high levels of leverage off the back of adjusted EBITDA multiples and were struggling with cashflow concerns. The industry is nervously waiting to see how revenues fare during the holiday season, with some concerned that one or more high-profile firms could fail to meet its debt obligations.

Of course, they never saw it coming. Lenders who had bent over backwards to accommodate pampered borrowers now found that agreeing to covenant-lite structures in pretty much every deal was not such a great idea after all. It meant there was no warning sign when the proverbial hit the fan.

And hit the fan it did. A no-deal Brexit, a surge in European populism, wars breaking out in various parts of the globe, highly aggressive trade disputes … all combined to give companies the jitters. One or two firms backed by private debt began to get into trouble and then you had a domino effect with one toppling after another.

Part of the trouble was that there was no market where you could easily buy and sell the loans. Many ended up being offloaded at deep discounts. Returns took a hammering: many direct lenders had promised returns juiced up by leverage on an adjusted cashflow basis. It was a recipe for trouble and many investors were wiped out.

Now, of course there’s always a bright side. Distressed specialists had a field day: all that capital that been building up in anticipation of the cycle turning finally found a home. Moreover, it had long been said that the burgeoning private debt asset class needed a crisis to sort the wheat from the chaff. It had certainly got one, and it turned out there was a fair amount of chaff.

Republican President Donald Trump’s unpopularity resulted in a partisan chasm wider than the Grand Canyon, causing Democrats to take back the House of Representatives, the US’s lower chamber of Congress, for the first time in eight years.

Incoming Speaker Nancy Pelosi and her Democratic majority will doubtless take plenty of measures to make life difficult for the Trump administration and stymying his deregulatory agenda will be among them. She may simply refuse to bring legislation to the floor that loosens financial regulatory shackles or actively promote bills that make life much more difficult for the big banks. Those financial institutions have yet to pile back into the mid-market, partly because the “red-tape cutting” that has made its way through Congress under the Republican majority has benefitted the smaller and mid-size banks. In addition, legislation often requires federal regulatory agencies to write new rules, a process that moves at a glacial pace.

The above reasons, though, did leave the door open for banks to see more accommodating policies enacted, should Republican-controlled Congress have begun enacting big-bank-friendly policies and federal agencies finalise new statutes. A Democratic House, though, negates any possibility, particularly with the party’s leftward drift.

An outcome few thought possible became reality on March 30. Despite frantic last-minute, back-and-forth negotiations between the UK Brexit negotiating team and their European counterparts, neither side could come to a compromise. Among the sticking points in the remains of UK prime minister Theresa May’s much-maligned Chequers Deal were unanswered questions over the Irish border.

As the news broke, the pound plummeted and in the coming weeks, huge supply chain disruption and a sharp rise in import prices, combined with inflation and falling consumption, drove the UK into recession. Unsurprisingly, those most affected were the sterling-denominated funds, thanks to a weak pound and increased hedging prices. The biggest pan-European funds were able to minimise the impact by shifting strategy to towards the continent.

On the other hand, the turmoil created opportunities for overseas distressed debt investors circling for a bargain. Now UK-based managers and fund administrators are faced with another headache: the regulatory status of UK funds with European offices. With no co-operation agreement, specifically under AIFMD, managers have been left paralysed by a lack of clarity over their status in each European jurisdiction.