MGG: What concerns credit investors?

This article is sponsored by AB Private Credit Investors

What’s up with the corporate leveraged loan market?

The two headline points are that covenant-lite loans are eating the world (in Europe, 95 percent of levered loans are cov-lite, according to JPMorgan Asset Management, and 80 percent in the US) and the leverage in those loans is very high. Indeed, real leverage based off a borrower’s actual EBITDA is even higher. This is due in part to the massive EBITDA addbacks that are now common in the private equity sponsor and broadly syndicated market. Such addbacks boost EBITDA as borrowers and lenders agree to give credit to future proposed cost savings that may, or may not, ever happen.

One example recently sported 5.2x debt/EBITDA with addbacks, but more than seven times without. That kind of nose-bleed leverage typically is a non-starter for us. Such high leverage is also one reason PE borrowers have a 50 percent higher default rate. There is a saying: little kids, little problems; big kids, bigger problems – it’s the same with leverage.

Anything even crazier happening?

Yes, sometimes it feels like The Twilight Zone. The crazier things get, the more you think they can’t get any crazier. Then something even more bizarre occurs.

First, rather than giving lenders thin reports quarterly, some PE and BSL borrowers now try to provide reports only every 120 days. We call this ‘info-lite’. In contrast, in the non-sponsor market, we generally receive much more detailed reports monthly. Second, PE sponsors are often able to move assets into unrestricted subsidiaries away from lenders. This is so-called ‘collateral-lite’. Third, PE sponsors are sometimes now able to eliminate the right of lenders to speak with borrower management. This we call ‘access-lite’. For borrowers, this is great. For lenders, not so much.

When is the downturn coming?

As baseball legend and coach Yogi Berra once said: “It’s tough to make predictions, especially about the future.” Rather than try to time the downturn, instead we try to put ourselves in a good place to excel and take advantage of a downturn by having a portfolio of defensive businesses and assets with low leverage, senior secured first lien with a lot of covenants. Plus, you need real workout expertise, through prior cycles, with proven success minimising losses.

What should investors worry about in this environment?

Credit investors are paid to worry about the downside. So, in addition to the longest US expansion on record, we worry about lots of things: from how resilient is the borrower’s business in a downturn, to leverage levels (nearing record highs in market deals, which we seek to avoid) to covenants (largely absent in PE sponsor and broadly syndicated loans) as just mentioned. Another risk, albeit rare and hopefully never an issue, is fraud, which luckily we have not had.

How can an investor mitigate the risk of fraud?

It is not easy, of course. Those who commit fraud are often skilled at hiding it. But experience teaches the keys are ‘don’t trust’ and ‘independently verify’. We try to do a few things to mitigate the risk: first, we typically hire our own independent forensic accountants to conduct an independent audit and quality of earnings review; second, we run detailed background and reference checks; and third, we do our own in-depth research and diligence.

One reason we prefer non-sponsored lending is we can do all of the above. In contrast, when dealing with PE sponsors and/or bank-led broadly syndicated loans, the PE firm and syndicating bank don’t want the lender doing independent diligence or having a direct open and ongoing dialogue with management either before or after the loan closes.

Have you ever spotted fraud?

Yes. During diligence in one deal a couple of years ago we identified varied orange to red (to blazing red) flags: signatures on documents that did not look real; alleged currency hedging that both made no sense and was allegedly being done for the company by a PE firm; people whose identities we could not confirm either in person or online; information that was unavailable because of “secret military national security” concerns. Both we – and our long-time seasoned outside counsel – sensed something was not right. We told the potential borrower we were pencils down until he resolved our concerns. We never heard from him again. Then months later the FBI called saying they had arrested him for fraud against a Texas bank.

Do you worry about changes in regulation?

Changes in regulation in specific industries tend to create more opportunities than not. As to the banking regulatory landscape: the 35-year massive consolidation in the US banking system (during which roughly 10,000 of the 11,000 small banks in the US have disappeared) has resulted in a structural opportunity unlikely to change for a material amount of time, if ever. New bank starts have plunged post-crisis and are all but non-existent. Online lending has increased, but our size borrowers can’t typically find our size loans online and, more importantly, would not want to borrow online. This is because in the event of a covenant breach or default, it is much easier to negotiate with a lender like us who is a seasoned lender and can work things out with the borrower based on decades of workout experience.

How do you think about changes in interest rates?

Our loans typically have floating interest rates with LIBOR floors. If interest rates go down, we are protected by the floor. If rates rise, our businesses, which are on average only 3x or so levered, should be able to pay the added interest without much hardship. In contrast, the much more highly levered loans common with PE borrowers or the broadly syndicated levered loan market could eventually feel real pain in the event that interest rates go up materially.

Anything else you worry about?

One thing we think a lot about is technology and disruption risk. We try to avoid sectors that are ripe for disruption. We actually like businesses that are benefiting from favourable technology trends such as our NHL team borrower (live sport is one of the few things people will watch and sit through commercials for, and is one reason sports teams have seen significantly rising valuations) or our airport concessions loan (longer security times force travellers to spend more time, and therefore more money, in airports). Then to turn things on their head we also like things that are in areas being disrupted or are out of favour but where we feel the leverage is low enough and/or the risk is materially mispriced, so the safety is a lot higher than others realise.