How has the market environment for private credit changed in the last 12 months?
This time last year, it felt as if we were in the last stage of the credit cycle. The market was characterised by robust capital inflows along with several new entrants, which led to heightened market competition. Unsurprisingly, this pressured transactions along a variety of dimensions, such as higher leverage multiples and tighter pricing. Most concerning to us has been the deterioration of underlying documentation terms – a development that could have a negative impact on recovery rates during a downturn.
Today these factors continue to be prevalent, and in some cases, have worsened. No one can predict with perfection when a market turn will occur, but managers need to be conscious of the long-dated nature of the current economic recovery. It feels a bit like the calm before a storm, but only time will tell whether we are nearing the end of this particularly expansionary credit cycle following the global financial crisis.
What changes to the documentation are you most concerned about?
The definition of EBITDA in the middle market has become subject to intense negotiation. For example, in many cases there are no limits on the portion of EBITDA that can be comprised of add-backs. There is also a general lack of accountability on the part of management to document and substantiate these add-backs, which is equally concerning This will likely lead to increased payment defaults in the future as adjusted EBITDA per the loan agreement and actual, realised EBTIDA may differ considerably.
Our second documentation concern relates to provisions that enable borrowers to extract collateral value from the borrower group to gain increased negotiating power in a restructuring. The first notable example of this situation occurred with US clothing retailer, J Crew, where material intellectual property – ie, the brand – was transferred out of the business, and extracted from what the lenders believed to be a key part of their security package.
More recently, a similar situation involving PetSmart has created concern among lenders. In this case, collateral value was transferred outside of the borrower group by taking advantage of loose document terms relating to allowed investments in minority-owned subsidiaries, which are not required to be guarantors under the credit agreement.
Lenders in both cases believe that their collateral has been removed, which will likely lead to higher losses. Both cases are still in litigation so the outcome is unclear, but it’s concerning for the market that we are seeing these actions being taken by borrowers.
What tools can a private credit manager use to differentiate itself in such a hot market?
I believe there are two key skill sets that a credit manager needs to be successful, particularly in the current market environment but also over the long term. The first is having strong fundamental investment skills. Being good at assessing, mitigating and pricing risk at a fundamental level will always be a key success factor in the asset class, but this alone is not enough to excel. The second key skill set is business building and management.
The unique aspect of the private credit asset class requires managers to build an operating business, rather than simply buying and selling securities in the market. Successful private debt managers will therefore have strong business building skills which creates differentiation. I believe that business model design and platform edge is as important as fundamental investing skills in terms of enabling managers to outperform in a challenging market environment.
Technology now represents the largest industry sector for leverage loans; does this concern you?
Growth in the software sector is driving this trend, and it does cause concerns. Software loans have performed extremely well over the years from a creditor perspective, which creates a sense of complacency in the market. Today, many lenders have the view that you can do no wrong in software, but we don’t believe this is the case. There are many newly established software lending efforts that we see bending or completely disregarding time-tested frameworks for lending to these companies.
“We feel good about private credit’s ability to create attractive risk-adjusted returns over the long-term, although recovery rates will likely be lower than in previous cycles”
For example, many companies offering software-as-a-service raise financing on a debt-to-recurring revenue basis, but this is only one metric and it can become a blunt instrument if it isn’t applied correctly. Specifically, not all recurring revenue is created equal. Sponsors commonly ask us what our comfort level is in terms of our maximum debt to recurring revenue for a SaaS business. We explain that we don’t have any hard and fast limits. Rather, the amounts we will lend depend on many factors, such as the company’s top-line growth rate, stickiness of the revenue base, projected lifetime value of the customer relative to the customer acquisition cost and, finally, the marginal profitability of each dollar of revenue.
But this isn’t the first time a growth sector in the private debt market has stretched its multiples – what is different about the current set of tech firms?
Historically, lenders lent to software firms based on an EBITDA multiple that was reduced for capitalised R&D costs. The R&D adjustment results in EBTIDA and operating cash flow being virtually the same. In the past, you may have seen software firms that are leveraged on this basis at 6x to 7x EBITDA, reflecting 50-60 percent loan to value, for example.
We now see competitors, particularly new entrants to the software sector, lending to these businesses on a multiple of EBITDA, without considering the ongoing need to invest in R&D. This could result in an actual debt to operating cash flow of 8x to10x. This is just one example of market excess, where rules that have historically applied to this sector begin to break down.
Are you actively positioning your portfolio for a downturn given the extended nature of this economic recovery?
It is very challenging to time when a cycle will turn, and one is likely to get it wrong more than they get it right. We have a philosophy of being active and selective in all market environments, and in this environment, I would emphasise highly selective. We are not looking to make a land grab for market share in the current environment. Rather, we seek individual opportunities where we can provide a customised and differentiated solution to our sponsor relationships.
We also focus on driving diversity across the portfolio to manage risk, including with respect to sector and single name concentration limits. Our portfolio is also overweight senior secured loans, including traditional first-lien loans and unitranche instruments.
Given the concerns over a potential downturn, how optimistic are you over the long-term market outlook?
We are cautious in the near term, but we also think that this is a viable and strong asset class that can outperform in tougher markets, certainly on a relative basis.
We also feel good about private credit’s ability to create attractive risk-adjusted returns over the long term, although recovery rates will likely be lower than in previous cycles. Returns through the cycle are therefore likely to be lower than before as well. This doesn’t mean industry returns will be unattractive. We still believe the industry will produce good relative returns through the cycle and believe the best managers will outperform.
Simply put, the key to success is asset selection and avoiding losses.
This article was sponsored by AllianceBernstein. It first appeared in the US Mid-market Report that accompanied the September edition of PDI.