This article is sponsored by KKR
The recession that seems to be looming might tempt investors to look for the safest parts of the capital structure. But Michael Small, a partner in KKR’s credit and markets business, says that the growth of covenant-lite senior debt has made private junior debt investing in large, well-capitalised companies in stable and resilient sectors ideally suited to the current macroeconomic environment. Private junior debt instruments, he says, occupy a sweet spot; they are a safer bet than equity investments, and offer more yield than fixed-income products without exposing investors to substantially greater risks.
How has the growth of covenant-lite loan agreements affected the attractiveness of private junior debt investing?
It’s been nothing short of a game-changer. Way back in the past, almost every senior loan had maintenance financial covenants. If one of those covenants was breached, it often gave senior lenders a massive amount of influence. Depending on who was holding the senior debt, they could negatively impact the value of the equity and, by extension, the value of the junior debt.
After the global financial crisis, the documentary construct evolved. Since then, documentation has generally become less lender friendly across both public and private credit markets. Notably, for companies that are big enough to finance the senior part of their capital structure through syndicated products, loans or bonds, we’ve seen maintenance financial covenants largely disappear. Today it’s very rare to see loans to companies with more than $100 million in EBITDA have maintenance financial covenants in senior debt.
Whilst this is an unwelcome development for senior creditors, it has been a positive development for private junior lenders because it reduces the risk of default, capital structure instability and restructuring during periods of contraction and temporary weakness in earnings.
We call this the “Documentary Paradox” and we don’t think the market fully understands it yet. Therefore, when we provide private junior debt, we feel we’re still getting paid based on historical perceptions of risk. We’re generating significant value for our investors just by making private junior loans. We do so in a disciplined way, by sticking to stable, resilient sectors and selecting large, leading businesses with talented management teams and good alignment of stakeholder interests.
What would you say to those who see private junior debt lending as counter-intuitive in current economic conditions?
Please think again! On average, the capital structure of the buyouts we finance with private junior debt might comprise 30-45 percent senior debt, a further 10- 20 percent junior debt, and 40-50 percent or more common equity.
In times of macroeconomic stress, risk is higher for everyone – whether you’re a senior lender, a junior lender or an equity investor. It’s almost impossible for a shareholder to make money if a company can’t repay its senior and junior debt. So, I would argue that junior debt is much safer than equity. While it’s higher risk than senior debt because of its position in the capital structure, it’s very unusual to have a company where the senior debt is fine, and the junior debt is bad – if a borrower has fundamental performance issues, all debt instruments will tend to be at higher risk.
I like the outlook for private junior debt because we’re lending to large, leading businesses with bespoke documentation where our returns are often in the low teens, all contractual, and predominantly floating rate. There’s generally more stability in gross margins and therefore more cashflow in large businesses than in small businesses in our traditional favoured sectors for private junior debt, including, for example, software, commercial and professional services, and pharmaceutical, biotechnology and life sciences.
Being credit investors, our focus is skewed to the downside risks. We’re always very cautious around the macro environment and aggressively stress test our models for macroeconomic, sector-specific and company-specific issues. When we make a private junior debt investment, we’re typically committing to an instrument with a long contractual maturity. We underwrite to the realistic worst-case outcome, because as a private creditor investor it’s often not viable to pull the rip cord and get out if things go wrong.
Is a generalist or sector-specific approach better suited to today’s market?
I think this is all about the benefits of diversification, whether in today’s market or any other market environment. If you take a generalist approach and – crucially – if you have a platform that is scaled, global and relevant, you can position yourself to source the best opportunities. That can give you diversity of sector, business size, location, transaction type and sponsorship.
The only thing that’s certain in life is change. You need diversity to protect against known unknowns. Having ubiquity of origination means that you can curate diverse portfolios with lowly correlated names you really believe in, which is much harder to achieve through market cycles if your addressable universe is sector-specific or country-specific.
Markets tend to operate in multi-year cycles – for most years in a cycle, you likely wouldn’t see an observable difference in performance between the generalist and sector specialist. It’s that one bad year in every cycle, where everything comes home to roost, that’s where you see the difference. That’s what we’re underwriting to, it’s the basis on which we construct our portfolios, and we expect it will become even more apparent in the environment we’re heading into.
If you look at long-term data, the funds of generalist private junior debt managers focused on larger companies have performed well through market and macroeconomic cycles.
How are LPs thinking about junior debt?
It varies a lot across type of institution and where they are in their alternatives programmes, but there are two allocation-related themes that appear in a number of our more recent conversations with LPs that I find interesting.
The first is an increasing focus on using private junior debt as a complement to traditional direct lending. It gives investors private credit exposure to materially larger businesses, thereby diversifying rather than concentrating risk. A feature resonating more and more given concerns around inflation and growth.
The second theme is one of relative value. Many LPs sit in one of two camps: an equity-oriented investor, who’s looking for something a bit more defensive, or a fixed-income investor, who’s looking for something that returns a bit more.
Equity-oriented investors have become more interested in junior debt today than a year or two ago, when the whole market wanted to buy growth. Now, given the macroeconomic outlook, people view having some junior debt in their portfolios as potentially interesting. It is downside-protected and offers an attractive contractual return.
LPs are not having to bet on growth and are not giving up a lot in terms of return to effectively buy that downside protection. I’m not saying that investors should make a direct replacement of a large portion of their equity bucket, but I do think some allocation to private junior debt could enhance portfolio construction.
Conversely, if you’re a liquid, fixed-income allocator, loans probably give you a return, through cycles, of around 5 percent. Private junior debt, for the same company, will return on average something in the low teens. I think this is an attractive premium as the incremental risk to the junior lender for high-quality companies is modest given average capitalisation structures and, of course, the “Documentary Paradox”.
I don’t advocate that this relative value perspective is applicable to every opportunity in every sector – far from it. You have to be disciplined, with fundamental credit analysis at the core of every underwriting decision. The good news is many top-tier, well-capitalised private equity firms like the sectors we like and will continue to use private junior debt.
What kind of ESG considerations are you focusing on?
For a long time, creditors had resigned to using a negative screening approach to ESG. We believe that is no longer sufficient.
KKR has been a leader in working toward integrating ESG considerations into its investment process. Several years ago, we stepped back and asked what we as credit managers could learn from our private equity colleagues, and how we could come up with a proactive, authentic and robust approach to identifying ESG risks and opportunities across our credit
At the core of our approach is a proprietary ESG Scorecard. We collect information on the activities of the underlying business and use the scorecard to evaluate it across a variety of ESG criteria using both internal and external frameworks.
We believe the lack of consistent disclosure standards for ESG data presents an industry-wide challenge. We take engagement and quality of disclosure into consideration when evaluating companies. Because of our ESG processes, we expect many of the new products we offer to be classified under Article 8.
Our approach also allows us to identify potential sustainability-linked loans, including opportunities to embed features that can positively incentivise borrowers to make progress on ESG KPIs. What’s most fulfilling here is not necessarily marking the ‘A’ students, it’s working with the ‘B’ and ‘C’ students and helping them improve. That’s at the heart of how we like to think about sustainability-linked loans. When they’re well executed and focused on meaningful and material targets, I think they can be very impactful, and I think we’re going to see more of them in the future.
What is the outlook for junior debt over the next few years?
At the moment, it’s a very unusual and attractive environment that I don’t think will persist. The liquid markets are effectively shut, which means underwriting banks are not open for business. If you’re a leveraged issuer today and you’re not investment grade, private credit is often the only realistic option.
But that’s not going to always be the case. The liquid markets are going to reopen, and the market will find a new equilibrium in terms of risk and pricing. Then we’ll get a new status quo in terms of market share between broadly syndicated products and private products.
Within that, what we all need as credit investors is M&A activity, because it pump primes the system. For all of us, the one thing that could lead to a less attractive environment is if we simply don’t get many new transactions for a prolonged period of time. I find it very, very hard to believe that that’s going to unfold. Provided the world keeps turning, and people keep buying and selling companies, there will be a need for financing, and the long-term environment for private junior debt should remain attractive.