With the holiday season approaching, delegates at our Capital Structure Forum in London last week could perhaps have been accused of giving Grinch-like responses to two poll questions that flashed up on screen. The first asked when a recession was likely to hit; most said it would be within the next 12 to 18 months. The second asked whether the private debt asset class was prepared for a downturn; more than half – 54 percent – said ‘no’.
A panel of investors then discussed how they and their managers should be getting ready for what our audience seemed to think was an inevitable dip. One proposal was to focus solely on businesses with stable cashflows – either contractual or at least ‘sticky’ – and build portfolios diversified by geography, industry and degree of risk.
Other suggestions designed to provide greater security in the face of headwinds included a close examination of current exposures. One panellist observed that a lot of funds were now backing private equity buy-and-builds that came with high operational risk and complexity. The implication was not that these deals were worrying per se, but that the degree of exposure was perhaps being underestimated and might need re-examining for appropriateness.
A further concern was whether senior debt positions are ‘true’ senior debt, rather than stretched positions with extra leverage. “You need to ask yourself whether you are genuinely at the top of the capital structure, which is where you want to be if a downturn is approaching,” noted one panellist. Another said they had placed a limit of 4.5x EBITDA on the amount of leverage in deals – a line that they refuse to cross, for the time being at least.
Investors said now was the time for their GPs to be as transparent as possible and to share copies of credit agreements so that LPs can take their own view on whether underwriting discipline has been exercised. They are also needing reassurance that fund managers’ teams are appropriately organised and incentivised.
But while being as prepared as you can is eminently sensible, the panellists appeared to share the negative sentiment expressed by delegates. There was a feeling that, when trouble hits, there will be plenty of negative consequences. Although documentation was acknowledged to be worse in the broadly syndicated market, there were concerns that at least some private debt GPs will have documentation issues that could ultimately force them out of business.
Moreover, with some claiming to be seeing signs of increased stress within portfolios, there are question marks over how effectively lenders will respond. According to one lender: “I look at counterparties in club deals and I’m surprised at the lack of engagement with sponsors when there’s a covenant breach. That engagement offers an opportunity to figure out what’s going wrong, but our sense is it will be difficult to pull people with us across the finishing line when a challenge comes along.”
By way of balance, it was acknowledged that a downturn would also bring opportunities. These could include survivors taking advantage of further bank retrenchment, buying opportunities in parts of the market facing a liquidity crunch, and the possibility for consolidation both at the portfolio and institutional level.
Furthermore, there’s no need to have nightmares about that downturn being just around the corner. “In 2020 it’s a presidential election, and you rarely get economic contractions during election year,” said one panellist, advocating the view that recessions can always be put off for another day if they really need to be.
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