The message couldn’t have been louder or clearer. Having enjoyed an ever-lengthening stretch of benign market conditions since the global financial crisis was finally shaken off, private debt professionals have been increasingly insistent that something at some point would come along and ruin the party. There was little in the way of complacency.
In line with expectations, along came the black swan. As is the nature of such things, it was virtually impossible to predict. Working from home, washing one’s hands, self-isolating when feeling under the weather… all things we did before, and all things that have taken on a new urgency in this peculiar chapter of history in which we now find ourselves.
For private debt professionals, the task of navigation begins. This will involve assessing the new landscape, one’s position in it, and what to do next. As with all areas of the investment world, there will be profound challenges ahead. But we all know that crises can offer opportunities for those who keep a cool head and read the signs well. Below are a handful of our early observations about the private debt market.
There are deal concerns, but there’s been a flight to safety There is little doubt that private equity-backed sponsored deals have been reflecting a growing bubble. In October, Refinitiv’s Middle Market Lender Outlook survey found the proportion of banks willing to lend at 6.5-7.0x had increased from 7.7 percent in Q4 2018 to 21.4 percent. The proportion of alternative lenders willing to lend at 6.5x or higher had increased from 26.3 percent to 36.0 percent over the same period. Strong leverage markets and the expectation of high earnings growth were supporting historically high valuations. Now, in the words of one mid-market adviser in the US who spoke to us, both of those supporting factors have been “vaporised”. The good news is that there has been a clear “flight to safety”. In a recent report, Coronavirus: Navigating the Volatility, Barings said it saw the best value in first-lien senior structures, which it described as “the traditional, true middle market”. Many other managers appear to have been thinking the same way.
As recession fears grow, distressed investors wait in the wings Amid huge reductions in business and consumer spending, recession fears are on the rise. After a tough Q2 and Q3, sources we have conferred with suggest a likely spike in corporate bankruptcies between Q3 and Q4. However, that’s only a best guess, and the game for distressed investors is all about the timing. They will be assessing who will be forced to sell and who will ride out the storm – possibly with government support. With any timeline for recoveries so unpredictable – since no one really knows how long the coronavirus outbreak will last – there’s the danger of catching a falling knife. One thing’s for sure, though: the appetite for distressed funds appears to indicate inspired timing. With 36 percent of the total raised globally, distressed was the most popular private debt strategy last year.
Dealflow may stall but LPs won’t necessarily be hit in the pocket If private debt has a lot of dry powder at its disposal, private equity has considerably more. However, in the short term – not least because of the difficulty of conducting meaningful due diligence – dealflow is expected to fall. This would inevitably have a knock-on effect for private debt managers largely reliant on PE-sponsored deals. What will they do as investment windows narrow? Will investor permission be sought to lengthen them? Will some capital be handed back? These are both possible, but private debt LPs have less to worry about than investors in other asset classes when it comes to cash sitting idle – the reason being that the norm in private debt funds is for fees to be charged on invested capital only.
LPs may refocus on the smaller end of the market There has been considerable frustration in the ranks of lower-mid-market GPs as they have seen most capital hoovered up by an elite group of fundraisers at the larger end. But there is a growing belief that smaller companies in need of finance will turn increasingly to alternative credit. Advisers have told us that interesting bolt-on acquisitions could arise for these firms. Debt fund managers will increasingly be the enabling source of finance.
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