Deep Dive: How is covid-19 changing private debt?

As governments stepped in to provide liquidity to stricken companies, the role of traditional lenders seemed diminished – and private debt stands to benefit

Amid the pandemic we are foreseeing a shake-up in the traditional continental European lending model, which is still dominated by banks. Regulators, corporates and small and medium-size enterprises will look back and acknowledge that banks were unwilling to offer their balance sheets for lending during the peak of the crisis – just when liquidity was needed the most.

Only after governments decided to step in with guarantees did most banks finally agree to fulfill their roles as financial intermediaries by injecting liquidity into the corporate and SME sectors. Still, funds did not arrive fast enough for many companies. In particular, the SME sector had to suffer from the banks’ lack of speed and efficiency in processing a large wave of credit requests, as seen during the initial stage of the crisis.

With this in mind, companies are starting to realise that relying on banks may not be enough to satisfy their future financing needs. Once governments decide to step out of the lending game, banks will be ill-prepared to assume the responsibility. Balance sheet ratios will look more challenging than before the crisis. Raising fresh money to meet regulatory capital requirements will be a major obstacle to growing existing lending activities. This is especially true for savings and cooperative banks that cannot easily tap into private markets to raise capital. Even banks with healthy balance sheets may be deterred from aggressively expanding their lending business at ultra-low margins in the face of heightened credit risks.

This is why we are expecting to see private debt take over an important share of traditional bank funding. Those private debt funds that successfully manage to weather the storm without severe blows to their track records will attract significant further capital inflows for financing larger corporations. In line with this, direct lending platforms will face tremendous opportunities in the SME market because of their technological capabilities in providing capital to small-sized borrowers at low cost.

‘Substantial edge’

Moreover, these non-bank lenders enjoy a substantial edge over traditional banks based on years of experience in analysing near-prime credit risks. These lenders conduct this analysis by using both traditional and alternative SME data on a large scale. The constant data stream provided by their borrower base feeds into proprietary credit models and allows for valuable insights into the financial health of the targeted client segment. It will be more important than ever to get timely information about the behaviour of individual business models as the long-term impact of the pandemic starts to unfold.

Solid companies with low leverage ratios, good credentials and strong balance sheets may continue to consider banks as their primary sources of financing – it’s just that there will be far fewer of these candidates around. For the majority of companies, banking solely on banks may become too much of a risk. It is time to look for alternatives.

Preparedness for a downturn and willingness to adopt flexible investment strategies have put some investors ahead of the game

While the covid-19 disruption continues to unfold and significant uncertainty persists, one theme that has emerged is the need for flexibility coupled with patience. Investors are appreciating that a well-designed private credit programme can both capitalise on market dislocations and produce a consistent yield, and that the best managers balance discipline and nimbleness.

Before the pandemic, when lending standards were declining and asset prices were near historic highs, Meketa advised clients to invest in ‘contingent’ or ‘trigger’ strategies to capitalise on a potential credit market dislocation. Recognising the structural governance constraints that make quickly closing new investments hard for many large institutional investors, the vehicles were structured as de facto call options on a market dislocation. Investors had made commitments, but the funds were not activated except in the event of a dislocation.

We designed these programmes, consisting of multiple managers, to be complementary across strategy, size and capital deployment, in order to access opportunities in the public and private credit markets. The managers targeted the tumult in the public corporate credit markets in March and April and have nimbly transitioned to the private markets, where they are exhibiting patience and discipline in deploying capital.

Blending stress and distress

The wholesale public credit market dislocation may have been short-lived, and this was likely to have been driven by the significant liquidity provided by the US Federal Reserve.

Opportunities, however, continue to evolve for longer-dated private credit. Liquidity-focused opportunities (such as capital solutions, rescue financing and special situations) remain attractive, if highly idiosyncratic. Significant capital has been raised to focus on corporate distressed, although the opportunity may be more industry-specific than investors first thought. Investors with flexible mandates that have the ability to pivot across stressed and distressed and offer creative solutions are likely to be well positioned to navigate the next leg of the dislocation.

As the dislocation dissipates and the recovery evolves, yield-focused strategies centred on new origination – such as mid-market direct lending, speciality lending and leasing – are likely to return to favour and offer attractive premiums in what will probably be a low-yield environment. In an environment that is likely to favour lenders, issuers should be able to secure more attractive terms as they relate to pricing, leverage levels and covenants.

Opportunities across multiple collateral types – corporate, mortgages, hard and soft assets – will enable investors to build out a diversified private credit programme. Such a programme will combine yield-oriented opportunities as well as market dislocation opportunities, and will be built around flexibility, discipline and an awareness of the credit cycle.

Tim Atkinson, a principal at Meketa Investment Group, also contributed to this article

Private debt is increasingly being seen as a replacement for broadly syndicated deals, bringing with it improved documentation

The market correction in March was short-lived, with the rebound affecting virtually all liquid asset classes. The secondary market opportunity in leveraged loan or high-yield bond markets was, with a few exceptions, only temporary.

Market observers will argue that the price developments in liquid global financial markets are not sustainable. What is likely to be enduring is the diminishing underwriting capacity of banks. This has been true for businesses in the mid-market for a while, but it is also affecting companies in the upper mid-market – those that would typically have had access to global leveraged loan or high-yield bond markets.

The hurdle for new issuers, especially smaller ones with no history in the broadly syndicated leveraged finance market, is higher. Unfortunately, market participants cannot wait for the leveraged loan markets to open up. This is where private debt funds are stepping up – at considerably better terms to what alternative broadly syndicated deals would have looked like.

They are doing so in two ways. Firstly, a private debt fund solution is increasingly viewed as an alternative to a larger bank underwrite. HPS’s financing of EQT’s acquisition of Schülke, announced in April, is one example. Normally, a business of the size and quality of Schülke – a leading provider of infection prevention solutions – would have been met with open arms in the broadly syndicated market. However, the benefits of dealing with one lead financing party have become more evident. Experienced private equity firms know how costly and time-consuming a drawn-out syndication process can be. Although a private debt fund solution will come with higher pricing, the borrower and sponsor do not have the uncertainty of ‘flex terms’.

Better pricing

Although there have been transactions led by private debt funds that exceeded volumes of $500 million, these often involved greater complexity. Recently, however, there has been a greater proportion of deals originally earmarked for the broadly syndicated market that were pulled in light of the market environment or that went straight to a direct lending solution provided by private debt funds. LifeStance Health in the US or Ardonagh Group in Europe are two examples. These deals came with better pricing (often 200-500 bps wider than what would be achievable in the leveraged loan market), more favourable call protection, and better documentation. This is in stark contrast to the covenant-lite nature of the broadly syndicated market.

Secondly, private debt funds are supporting broadly syndicated deals through anchor offerings. GSO’s €775 million equivalent position in the first-lien debt of the Skyscraper Performance financing (formerly BASF Construction Chemicals) will have come at a price: notably better documentation. The changes necessary for the terms of the ThyssenKrupp Elevators transaction point to longer-lasting changes to larger, syndicated deals: better terms for the private debt market and credit investors more broadly.

Private debt funds are now receiving first calls from private equity firms, as the pandemic reinforces the relative safety of the asset class

In 2004, when Park Square Capital had launched its first private debt fund, the only viable option for a private equity firm that needed senior debt financing for a large deal was to work with a bank and accept its default deal structure. This year, banks are no longer receiving that first call. Private credit firms have become the relationship lenders to private equity firms and have the capacity and flexibility to support buyouts of all sizes.

Since 2004, assets in private credit have grown from under $100 billion to more than $800 billion, developing from a peripheral market segment to playing a fundamental role in the economy and society. This growth will continue over the coming years, given the factors that are driving the market.

The demand from LPs to invest in private credit has been fuelled by the search for yield. As global interest rates remain historically low, pensions and insurance companies need to find alternatives to traditional fixed-income strategies. As a result, private credit is playing an increasingly important role in society by helping these institutions to meet their liabilities. As the understanding of private credit and its low levels of volatility versus equities has increased, so has the capital allocated by investors to the asset class.

The pandemic has also demonstrated the relative safety of credit. Prudent managers, focused on high-quality companies operating in stable industries with recurring revenues, have fared well. The ability to show a track record of reliable credit selection through multiple crises is key, and we expect the pandemic to spark a flight to such quality debt managers.

The decision by regulators after the global financial crisis to discourage banks from taking risks with depositors’ funds has also driven the growth of private credit and contributed to the stability of the banking system during the current upheaval. Private credit firms have largely replaced banks in the leveraged loan market, which has led to improved risk assessment and capital allocation.

Collateralised loan obligations have also grown significantly in recent years, and now account for around 54 percent of the US loan market. However, CLOs are experiencing unprecedented pressure because of their exposure to ratings downgrades – it is estimated that 51 percent of US CLOs are exceeding their CCC-rated bucket – and CLO liabilities are trading at significant discounts. It is difficult for CLOs to form new capital, and their ability to play a key role in the market has been curtailed.

As a result, deal structures have become more robust through the pandemic, with CLOs in need of higher-rated credits and private debt firms focused on downside risk protection. This improvement in pricing and terms will drive strong risk-adjusted returns for credit managers, as the primary market reopens following the lockdown.

Firms must act responsibly when negotiating deal structures, loan documentation and pricing to ensure that risk is correctly evaluated, and that investors’ capital is both protected and properly rewarded.

The part of the distressed market that can generate the highest returns may be under threat from central bank intervention

The distressed and special situations opportunity set is one of the most exciting areas for clients to invest in. Our clients were already prepared for distress and had a variety of new funds investing in or pivoting towards distress in March. However, the distressed cycle may be different this time around, in large part because of the unprecedented amount of central bank and government fiscal support that has been provided to offset the economic impact of covid-19.

A typical distressed cycle usually involves three separate phases.

Phase one involves traded credit, where high-quality companies trade down for technical reasons. This phase is already over in the current cycle, having existed in March and April before the speedy snapback in yields.

Phase two is the stressed and distressed phase we are in now. It involves corporate distress and impaired balance sheets owing to leverage levels being unsuitable for covid revenue stress. It typically lasts around four months to a year, and has been particularly acute in covid-affected sectors such as airlines and hotels. I believe this second phase started in May and will continue until around mid-2021, when we expect fiscal stimulus will be slowly unwound.

Phase three is usually the ‘main event’ for distressed. It involves more traditional forms such as bankruptcies, restructurings and non-performing loans. This is where the returns are typically highest (20 percent-plus) and where investors benefit from investing via locked-up capital vehicles. This phase normally takes place from around 1.5 to five years after the dislocation event. If events follows the normal cycle it will not start until the second half of 2021, when stressed companies will have exhausted all other credit sources and start to default in larger numbers.

However, a decade of intervention by central banks has trained them to believe they can consistently support markets. The US Federal Reserve’s unprecedented intrusion into new credit market sectors – such as collateralised loan obligations, real estate investment trusts, high yield debt and bond exchange-traded funds – also means phase three may not take the normal pattern.

It may instead be truncated, like phase one, and markets will not clear because of the volume of intervention. There has been $11 trillion of central bank purchases and fiscal support globally, plus a significant amount of capital withdrawn from low yielding bond instruments that is looking for a home.

This excess liquidity, combined with central banks’ promises of years of low interest rates, may lead to ‘zombie capitalism’, as experienced in Japan. Companies that should default would instead be able to borrow at low rates, leading to lower default availability for a large volume of newly raised distressed funds.

Our sources confirm there are many funds in the market raising capital and, if they are successful, more than $70 billion will be waiting to be deployed into phase three distressed from next year. If stressed companies, buoyed by covenant-lite loan terms, do not default in large numbers, there may be a shortage of opportunities for these specialist distressed funds.

With a focus on home markets and greater emphasis on ESG, private debt has a chance to lay the groundwork for lasting relevance

We are going through a major reset. Business models are changing at a pace not seen before and the impact will be massive. We are entering a period of reassessment and reflection at many levels.

At the portfolio level, we do not know the full impact yet. As companies and geographies face uncertainty, we have to remain humble about our ability to predict winners and losers. There are many moving targets, including subsidies, vaccines, a potential second wave, supply chain disruption, relations with China, available liquidity for refinancing, and cost of debt.

At the business model level, there are many dilemmas. GPs need new ways to execute and monitor transactions. Asset owners will reflect on internal versus external capabilities and relative value. Many asset owners, insurance firms and pensions have invested resources in real estate, infrastructure debt, corporate debt and private placement structures. They have done so via manifold set-ups – as direct investments, and sometimes with other managers through separately managed accounts or partnerships with banks or through fund structures. The performance of these investments is under scrutiny by their own management, risk and audit functions, their boards and by regulators.

Continued shift

The shift to private markets and alternative assets will continue as banks retreat from new business and focus on portfolio issues. Investors will maintain their quest for income-generating assets. There will be increasing high-net-worth investment solutions initiated by private banks and wealth managers.

The reset will coincide with better risk-adjusted return opportunities. In debt structures, there will be a greater focus on agility. There will be a more flexible approach towards structuring credit to offer investors benefits from the upside as well as downside protection – overall, this will mean a higher cash and liquidity buffer.

The pressure for operational and financial efficiency will facilitate bifurcation in the market and increase consolidation. There will be a greater focus on investing and partnering with GPs that master digital asset origination strategies in order to reduce costs and add real value.

Asset owners will face political and regulatory pressure and moral hazard to focus on investments closer to their home markets. The trends for finding assets with strong environmental, social and governance characteristics and creating ESG products will prevail.

In every crisis, there are winners and losers. I believe private debt, with its different business models, has a unique opportunity to demonstrate its relevance to clients.

During the current crisis, there is also the opportunity to strengthen relations through open, transparent communication and loyalty to both investors and borrowers. Instead of building financial models with long-term assumptions, the relevance of reading signals and acting on them will increase. All eyes will be on those that create long-lasting value at all levels.

With due diligence having been made tougher by travel restrictions, parties to deals are asking more questions than ever before

The short answer, when observers ask how underwriting will change, is that there should be no discernible differences between the standards pre- and post-covid.

At Monroe, every deal on which we perform due diligence has been underwritten on the premise that the borrower will have to operate through some type of downturn. And regardless of whether a V- or W-shaped recovery takes hold, or the economy continues to experience fits and starts, lenders will have to view prospective credits under the assumption that output will remain below peak levels for the foreseeable future.

The biggest differences in underwriting relate to how lenders perform due diligence, their anticipated returns and the risk they are willing to accept.

The most obvious change to the diligence process stems from restrictions on travel. Lenders are relying on video-conferencing to conduct management meetings and facility visits and to produce quality-of-earnings reports. Video calls are used to conduct facility tours and, in some cases, there has been talk about using drones for larger site visits. But even without travel, the diligence process will take longer and require multiple rounds of questions and answers to ensure all parties access the required information.

As it relates to investment returns, covid-19 has resulted in a need for increased pricing to account for the greater uncertainty associated with lending. Leverage multiples are a turn to a turn-and-a-half lower than before the pandemic. There has been a tightening of covenants and credit documentation to protect against leakage in the form of dividends or assets being transferred out of lenders’ control.

Opportunity set unchanged

Lenders and sponsors have a clear preference for companies operating in recession-resistant industries. At Monroe, even before covid, our largest concentrations were in software/technology, healthcare and business services, all of which are generally performing well this year. We have largely avoided borrowers operating in traditionally cyclical end markets in recent years. The opportunity set for us is largely unchanged.

What has changed, however, is the mix of non-sponsored dealflow. These family-owned, management- and entrepreneur-led companies have been crowded out of the market over the past few years due to high valuations and intense competition from private equity firms. It has been Monroe’s experience that periods of volatility in the economy result in more actionable dealflow from non-sponsored companies as private equity sponsors focus on playing defence with their existing portfolio companies and valuations are less elevated.

Taken together, the dynamics in the direct lending market brought about by covid present new challenges in underwriting. However, they also present interesting opportunities that should amplify returns in current fund vintages, assuming that lenders remain disciplined in their underwriting and vigilant in their portfolio management.

More transparency, battle-hardened GPs and consolidation – all factors that could open up investor access to lower mid-market businesses

Crises often accelerate underlying trends by clearing out imbalances. Private credit, or ‘shadow banking’, looked to have an uncertain future in the aftermath of the global financial crisis, before going on to become a trillion-dollar alternative asset market.

Unfortunately, the covid-19 crisis will initially accelerate unsustainable trends in the private debt market. The good news is that this will bring forward the unwinding of those imbalances, and this in turn should deliver a healthier overall market.

Fundraising in 2020-21 will be further concentrated in the hands of fewer GPs, thereby exacerbating a five-year trend. LPs are re-upping with existing managers or engaging with the biggest firms. These elite GPs are likely to execute fundraisings that surpass the $6 billion-plus mega-vehicles of 2017-19.

Private debt will still be looking to finance big deals. Fund sizes may increase, but average granularity will remain at less than 30 assets per vehicle. This will drive liquidity for larger buyouts, with private debt players stepping in even if the high-yield market takes a break. The market is likely to remain largely covenant-lite. Definitions of EBITDA will remain open to interpretation while borrowers and lenders work to agree acceptable leverage multiples.

‘Refinancing tide’

The imbalance is that surging demand for private corporate credit is going to come from the lower mid-market and small and medium-size enterprises. Successful niche businesses in those sectors will be looking to grow or acquire. A tide of demand for refinancing will ensue when government stimulus loan packages come due.

If private debt were equipped to lend into these ‘real economy’ sectors at scale, there would be a big opportunity for LPs to invest in low-levered, conservative deal structures with high returns. But this is not yet the case.

So, although the covid crisis will initially exacerbate this market imbalance, how might the unwinding be hastened for the ultimate benefit of LPs, and by when? The crisis will provide useful data about SME lending and speciality finance. Businesses offering more data transparency and comparability are competing to provide data services to LPs. This sector trend is being sped up by the shutdown in face-to-face roadshows and conferences.

We will see ‘respected survivors’ emerge during 2021. Some lower mid-market GPs and SME lending platforms will come through with relatively clean portfolios. Some will achieve the critical mass to raise more regular, larger and more granular funds from large LPs and provide a real alternative to large LBO financing.

Consolidations among GPs will see lower mid-market strategies in the hands of large, diverse alternative investment firms. This will give LPs comfort that the counterparty risk is no greater. These ‘department store’ managers will offer more diverse options.

By 2022/23 we should see a more diverse investing gene pool as we connect the savings system with more sectors of the ‘real economy’.

Before the pandemic, deal terms were weighted firmly in favour of borrowers. Might the resulting volatility be the saviour of the covenant?

When a bank agrees a mortgage, its chief concern is whether the home buyer can repay the loan and, if circumstances change, that the bank has the ability to step in and realise the value of the asset. The same considerations are true for a private credit firm looking to lend to a company, and this is why strong covenants are so important in protecting lenders, especially in times of heightened uncertainty.

The competitive nature of the primary market for quality loans meant that there has been a race to the bottom to offer the most favourable terms for the company. The consequences of this have become apparent during the recent market turbulence. Covid-19 marks a turning point for the industry and will trigger a shift back towards stronger documentation.

Among the key parts of any loan document are the financial covenants. These are promises entered into by the borrower to maintain key financial metrics that allow the lender to ensure the business can repay the loan. Removing these covenants allows the borrower to reduce the complexity of the documentation and the amount of time it takes to renegotiate the loan, and provides the company with more flexibility, particularly during more difficult periods.

However, watering down covenants can be dangerous because they also provide the means to catch and address potential issues early. This is important because the earlier an issue is addressed, the better the outcome usually is. For example, if a company experiences a 20 percent reduction in revenues, there are usually measures that can be taken to help shore up the business and get it back on track. But if the company has a cov-lite structure, lenders often cannot take action until it is too late to help.

Defence against aggression

The prevalence of cov-lite deals is made worse by the adoption of ‘white lists’, which are designed to keep loans in the hands of a small number of preferred investors in order to stop more ‘aggressive’ lenders from buying in via the secondaries market. The unintended consequence is that when cov-lite loans perform badly, lenders often have no exit route and no means to take action to help the issuer. They must either hope the business recovers or write off their investment.

Another common issue in loan documentation is the use of ‘adjusted EBITDA’. EBITDA is used to provide an accurate picture of a company’s performance and the level of the debt that is sustainable for the business. Inflating this figure to include the effects of future events that may not happen, or to take into account the potential impact of unforeseen events such as covid-19, only distorts the picture and can leave companies over-indebted.

Just as mortgage providers are becoming more scrupulous with those they lend to, the recent contraction has reinforced the importance of strong covenants and sensible provisions in private debt. Lenders rely on this documentation to safely deploy capital in order to increase liquidity and assist struggling companies.

Covid-19 may have exposed weaknesses in aspects of the relationships between sponsors, investors and lenders. Might things change, or are certain practices set in stone?

I was once asked: “What is the most important covenant?”

The one that I consider to be the absolute must-have when underwriting any investment is alignment. Who are we doing business with, and why are they ‘hyper-incentivised’ – meaning they have far more ‘skin in the game’ relative to their resources than we do – to ensure that we realise a successful outcome? There is nothing more powerful in determining your probability of being repaid, and those who do not fully appreciate that tenet are starting to pay the price in a variety of ways (and with more to come).

GP-LP relationships are often fraught with misalignments. A GP might have little skin in the game. It might regularly ‘reassure’ its investors by agreeing to short-sighted requirements, and then act in a way that still maximises its fee revenues at the expense of those same clients – the essence of moral hazard.

You prefer to buy a product that is narrowly constrained to the opportunity of the day?

Of course, but it is unlikely to remain this attractive for six years. And if it does go out of favour, don’t expect me to return the money – I’ll just blame the ‘perfect storm’ and tell you about how the next vintage is going to be great.

A lower management fee? Sure thing – I’ll just raise more money than I had initially planned. A higher performance hurdle rate? OK, I will just take more risk if I’m underwater. The list goes on and on.

Another curious relationship is that of the private equity sponsor and the lender, where the presence of a sponsor is casually interpreted as greatly reducing risk. After all, sponsors perform thorough due diligence, have professionals with distinguished resumes and expertise, and bring capital to the transaction – including their ‘commitment’ to inject future equity when needed. Never mind that they are ‘adjusting EBITDA’ to whatever will raise the most debt possible and at whatever price is necessary.

You’re in the money

If they find themselves in a situation where they are out of the money and you as the lender are in the money – as we are seeing today – you shouldn’t expect friendly capital injections that stabilise the underlying business and mitigate lender risk. Nor should you expect pricing accommodations that compensate lenders for the equity risk they are now assuming in the absence of sponsor support.

Will this disregard for alignment change as a result of covid-19? I hope so. But hundreds of years of empirical data in creditor-borrower relations would suggest otherwise. Despite all the hundreds of billions of dollars that will be wiped out, the incentives remain too great.

As Warren Buffett’s business partner Charlie Munger once said: “Show me the incentive and I will show you the outcome.” This has never been more important than today, and we would all be better served by its serious consideration.