Over the past decade, forecasters have been anxiously tracking rising corporate leverage levels and the proliferation of covenant-lite loans, while lamenting the woefully declining credit quality of borrowers. It would be a matter of time before we witnessed an apocalyptic deleveraging event that would finally mark the end the current debt cycle. The sovereign debt crisis, tariff war and inverted yield curve all came and went, but a global pandemic should have been the final straw.
By Q3 defaults fell to below pre-covid levels and yields declined dramatically. In a shocking turn of events, debt issuance surged to record levels, providing liquidity to healthy and distressed borrowers alike. The ultimate irony was, as S&P Global noted, investors “were so supportive that some of the corporate sectors that saw the largest increases in bond issuance relative to the prior five years were those most negatively affected by economic lockdowns”.
Undeterred, commentators rolled forward their doomsday forecasts, bracing for an even bigger deleveraging and fallout in 2021. Have we collectively “broken” the corporate debt cycle? Consider the following factors.
Fed backstop. The US Federal Reserve has been involved in unprecedented direct lending to both investment grade and distressed borrowers. The Fed’s balance sheet nearly doubled to $7.4 trillion, all but ensuring it will be a permanent participant in private credit. Markets are in ‘risk-on’ mode, and it is difficult to imagine any kind of crisis of confidence in the foreseeable future.
Near-mythical ‘search for yield’ and the prolific rise of non-bank lending. Institutional investors, grappling with falling returns on fixed income and other assets, have pushed deeper into the private credit market. Assets under management at private debt funds has skyrocketed from under $200 billion in 2007 to nearly $900 billion, with $300 billion of dry powder waiting to be deployed. The new breed of lenders is more creative and better equipped than traditional banks at segmenting and capturing risk premium at all levels of the capital structure. For these lenders, covid-19 has become a mere EBITDA adjustment, and most were willing to ride out the storm into 2021 leaving the search for yield poised to continue unabated.
Evolution of lenders’ strategic options for dealing with distressed loans. Historically, a bank loan workout was a lengthy affair. Today’s lenders prefer to move quickly to exercise their remedies. They turn to secondary debt sales, special situation refinancings, carveouts or expedited sales. Increased specialisation means there are buyers for every type of security, asset and distressed business. For deeply troubled credits, options such as Article 9 foreclosures or Section 363 sales can be used as a tool to efficiently foreclose, sell viable assets at premium prices, and wind down remaining liabilities through in- or out-of-court processes.
As a mid-market financial advisor, G2 employs these strategies every day on behalf of our clients and has witnessed first-hand how lenders can dynamically shift risks throughout this ecosystem. Lenders rely on G2 to provide financial and operational support, integrated banking capabilities and advanced legal sophistication.
Could this mark the end of the broad-based credit cycle, and the start of an era characterised by complex, localised pockets of risk accompanied by fewer, but larger, distressed events? The current debt cycle may live on for some time yet.
Konstantin Danilov is a vice-president at G2 Capital Advisors, which provides M&A, capital markets and restructuring advisory services to the mid-market