Owning risk

There are plenty of warning signs, from frothy high yield markets to the proliferation of cov-lite structures. Yet these mask a new recognition that banks aren’t the most appropriate end holders of risk.

There was an interesting piece about debt in the Financial Times earlier this week. The author made some apocalyptic predictions about the future health of the US economy, largely based on the assumption that people simply haven’t learnt the lessons of the credit crisis.

There are plenty of examples to support that view. Energy Future Holdings, formerly known as TXU, is teetering on the brink of bankruptcy thanks to its massive debt burden and the emergence of shale as an alternative to conventional oil-based power generation in the US.

There’s also the moderately alarming statistic that covenant-lite deals accounted for about half of leveraged loan issuance this year, compared to only a quarter in the heady days of 2007.

None of this is trivial, but it should also be acknowledged that a very important shift in the market’s mindset has occurred. It’s now widely accepted that the owners of risk shouldn’t be banks, in whose case default has far-reaching systemic implications as we saw with the credit crunch. Rather, it’s increasingly the view that private investment groups (and in turn their investors) might be better suited to being the end-holders of this risk.

Incentives for a private debt fund manager are tied so intimately to fund performance that risk analysis and due diligence become absolutely integral to success. Get it wrong, and there simply isn’t the backstop many banks enjoy of a slew of other divisions to hide poor performance, and there’s also the fact that a GP will have committed his or her own capital to the fund. And a one percent management fee might pay the bills for a private debt fund manager, but it won’t make him or her rich. Thus success is predicated on delivering true alpha, and avoiding mistakes. 

A traditional fund structure is just one of many ways to invest in credit however. But look around, and other structures are equally well suited to ‘owning’ risk. CLOs have a remarkably good record through the downturn in terms of default and recovery rates, and BDCs haven’t fared too badly either.

There’s no doubt the high yield market has been overheated this year, and the quality of issuer has been on a downward trend as companies strive to tap that source of liquidity whilst there’s still a thirst for (albeit much reduced) yield. But high yield still offers a better return than government bonds, and should the bubble burst, it won’t have Lehman-esque consequences, although there will be plenty of tears.

And as the FT’s piece noted also, leverage multiples are considerably more prudent than they were in the boom – only one in 20 buyouts this year had a leverage multiple of more than 7x, compared to a third of 2007-vintage deals. The spread on leveraged loans at present remains above average. Furthermore, the reduced leverage levels have also played a part in sponsors’ ability to negotiate covenant-lite terms, several sources tell Private Debt Investor.

Yes, the market in the US has become frothy, but it’s worth noting that banks, whilst still clamouring to underwrite bigger deals in particular, are holding less debt on their books, and syndicating in greater volumes than before. We have regulators to thank for that of course, a maligned group who in this case have helped to bring about a shift in attitude which happily plays into private debt investors’ hands. The real danger will come in five or six years’ time, when loans issued in this market have to be repaid. And with interest rates likely to rise, refinancing those loans won’t be an attractive proposition. That too will provide an opportunity for private debt though.