The GFC: A dramatic reshape of the lending landscape

Life would never be the same, and lenders were among those trying to make sense of it all. Andrew Hedlund reflects on several key ways in which the private debt asset class was moulded by a crisis.

In the week of 8 September 2008 – the last seven days of Lehman Brothers’ existence – one large alternative credit manager had arranged a syndicate of lenders to back an Alaska-based fisher and canner of tuna. All that was left to do was sign the commitment letter.

Over the weekend of 13-14 September though, the lending landscape changed, with Lehman ultimately seeking court protection the following Monday. Three Icelandic banks that were in the lenders’ group failed, leaving the credit manager without a complete syndicate. When the world seemed to be crumbling around it, what’s a firm supposed to do?

Reconfigure the deal to include higher pricing, and ultimately close the transaction.

The global financial crisis would dramatically reshape the lending landscape, and though the firms involved in the above deal may not have realised it, the deal was a harbinger of what would become a key selling point of private credit to private equity sponsors and other businesses: the ability to deliver on transactions even when the going gets tough.

The GFC put the asset class is in a unique position among alternative investment strategies. Private equity and real estate had become established before the 2007 downturn, and high-flying hedge fund managers raked in billions of dollars.

Without the GFC though, private credit wouldn’t be what it is today, or at least there would have been a very different path to establishing the asset class as a serious fixed income alternative and worthy of its own portfolio allocation for some limited partners.

The fallout from the crisis and the regulations put in place in response to it hampered banks, particularly the leveraged lending guidelines, market sources tell PDI. Those statutes established a guideline of up 6x total debt/EBITDA as an acceptable level of risk, though it was not viewed as a “bright red line”, according to Federal Reserve implementation guidance.

But the ensuing regulatory crackdown and retrenchment of the banks is only one part of the story. Below are additional takeaways.

Alternative lenders compete against large banks for deals

Separate and apart from banks leaving mid-market lending, the largest credit managers can now compete for deals that run into the ten digits.

Hold sizes have got larger in the wake of the GFC. Alternative credit managers could take down approximately $15 million to $30 million before the crisis, while most can write cheques of $50 million to $75 million or more today, said Michael Chirillo, an Antares Capital senior managing director who leads the firm’s capital markets group.

That’s not even taking into account the largest firms, which can rival deals arranged by large investment banks. When Ares Capital Corporation, Golub Capital, TPG Specialty Lending and Varagon Capital Partners all helped underwrite a $1.08 billion unitranche facility to back a Thoma Bravo buyout in early 2016, people took notice. Ares itself held a “couple hundred million” of the total loan, according to a source.

The GFC provided lessons in downside modeling…

The downturn in 2008 exceeded many credit managers worst-case scenarios, something that likely gave downside protection a whole new meaning to many financial firms.

“The thing that’s easier about our job today is that none of us had ever really lived through a severe economic contraction,” one credit manager noted. “Now, almost every deal we do has data from 2008-09. You feel a lot better about how the [borrowing] business is going to do in a downside scenario than you did in 2007.”

Part of that downside scenario includes deciding when to pump additional money into a portfolio company, an unsavory decision many private equity firms and lenders had to make during the crisis.

“On the corporate side, we saw companies that needed capital where we or their lenders had choices to put capital in and make it through the crisis, or you had to be willing to walk away,” Ivan Zinn, founder partner and chief investment officer of Atalaya Capital Management, said.

“When we look at investments in this part of the cycle, we have to understand the risk of having to put more capital in, putting good money after bad,” he added.

One upshot of the crisis is that equity cheques into mid-market LBOs are well above their pre-GFC low of 32 percent in 2007. Equity contributions for the first two quarters of the year are up 11 points from that figure, as mid-market LBOs saw 43 percent of their capital come in the form of equity.

…though whether credit managers heed those lessons is another story

Covenant-lite transactions have made up the lion’s share of the leveraged market for years, but the march continues upward, according to data from Covenant Review.

Of the newly issued institutional term loans with tranches above $250 million, cov-lite loans have crept up from about 75 percent in the first quarter of last year to almost 98 percent in the second quarter of this year.

“There were covenant-lite deals [pre-crisis], but they tended to be larger, more liquid credits,” Chirillo said. “But now you do see middle-market transactions getting done on a covenant-lite basis.”

In a recent survey by William Blair, 63 percent of lenders said they would consider lending a cov-lite or cov-loose loan to a sub-$50 million EBITDA business, a figure often quoted as the top end of the mid-market.

The above equity cheques may mitigate some of that risk, some say. “The counter balance is that sponsors put their money where their mouth is. Equity contributions are above 40 percent for middle-market LBOs,” Chirillo said.

Others still see somewhat dubious claims being made as the GFC fades further into the rear-view mirror.

”It feels like more and more risk comes into the system because people haven’t lost money in a while,” Zinn noted.