This article is sponsored by Paul Hastings
What is the state of the market on new issuances as compared to before the covid-19 crisis?
Jennifer Yount: Before covid-19, in the fourth quarter of 2019 and at the start of 2020, direct lenders were already shifting focus. Many felt that the over-confident market needed some correction, and were moving away from the highly-competitive acquisition financing market into areas with less competition, including lending to venture-backed business. 2019 was a particularly strong year for fundraising globally. As we began to navigate covid, many direct lenders had already achieved their fundraising goals and had capital to deploy.
Then, the pandemic hit and they regrouped. Many are now sitting on capital to deploy and they need to invest that capital, in some cases before the end of this year. It is clear there is a lot of dry powder out there and that is a fundamental difference from the global financial crisis of 11 years ago; that dry powder is a game-changer. We are seeing an uptick in new issuances, going from venture debt to special situations and up and down the capital structure in all combinations. The direct lenders are flexible and opportunistic, and August was one of the busiest months I have seen.
William Brady: In spring, people were trying to figure out what was happening, but since summer, it is a tale of two worlds. There are companies that went into covid-19 with good balance sheets and are not in the severely impacted sectors, where lenders are supporting refinancings, sale events or strategic acquisitions. However, there are the companies that were already unstable going into this, or in sectors that are in retail or hospitality, where as a result of the pandemic, the demand is for liquidity solutions and the issue is defence rather than offence.
Which sectors have been hardest hit by the pandemic and which sectors have continued to perform?
Justin Rawlins: There are a number of sectors like retail, hospitality, and oil and gas where the hit has been really hard. Then there are other sectors that remain question marks, like hospitals, some of which have lost billions of dollars due to a lack of elective surgeries. Other sectors, including those related to travel and airlines, also remain highly stressed. In commercial real estate, however, there has not been as much distress “to date” as we had expected. We do expect a number of significant real estate restructurings in the future.
Jennifer Hildebrandt: The industries that have done well in recent months are the technology industries, including (though not limited to) virtual and online services, healthcare and pharmaceuticals (maybe apart from elective surgeries), nutritional supplement businesses, and video game companies. Technology and software companies have been the focus of intense competition among lenders – that was the case before covid-19 and has only intensified.
For new issuances, what type of investments are non-bank lenders making?
JY: This is the most eclectic market I have seen in my career, and a creative approach is at the heart of it. If companies are going to adapt and evolve, they need really innovative solutions from their lenders, so we have seen a wide range of structures covering senior, junior, first lien, second lien, unitranche, mezzanine, first out, last out, super-senior, preferred equity and hybrids of all of the above. Borrowers are calling direct lenders asking them for solutions to problems not seen in the past during similar economic pressures.
In what areas of special situations are you seeing the most activity?
Matthew Murphy: The specifics of a particular situation – the industry, geography of the borrower, financial situation of the borrower pre-pandemic, the lenders involved – determine whether you have a very active situation requiring immediate attention or a slowly moving collaborative process creating more runway for a borrower to address its issues. In some situations, clients enter into amendments, easing covenants, changing rates or deferring payments; other times, if the borrower was in distress prior to covid-19, the situation may need to be addressed more aggressively. Under either scenario, it is imperative to be proactive and be prepared to address a problem before it arises.
WB: The fundraising we see in special situations is indicative of how nimble direct lenders are. Many have shifted from junior capital to special situations and we are starting to see the deployment of that cash in recent deals. We are seeing a wide array of special situations work, whether on restructurings for existing managers or looking at new opportunities for clients that want to invest. On the new opportunities, the issue is finding ways to invest where you can get the consent of the necessary parties, where you can navigate a complex credit agreement, put cash into the business and map an exit.
What are the top issues facing non-bank lenders in the face of a global pandemic?
JY: One is uncertainty, not just in relation to the pandemic but also political uncertainty, M&A market uncertainty and so on. Direct lenders were initially focused on helping companies through covid but are now much more focused on post-covid plans and projections longer term.
WB: The uncertainty of the current situation, combined with pressure on managers to deploy capital and the underwriting pressure to invest wisely, really puts a premium on managers doing an even deeper dive in terms of due diligence. They need to be looking under the hood to make sure they get it right from a credit risk perspective.
How have the non-bank lenders approached their troubled credits?
JH: For companies troubled before covid-19, the pandemic has accelerated that downward trajectory. Where companies have become troubled directly because of the pandemic, nonbank lenders have taken a measured approach, looking closely into the trajectory post-covid and modelling for recovery. We do not expect the “measured” approach to last indefinitely, and lenders will expect their borrowers to learn to adapt to the crisis.
MM: It is important to take a deep dive into each borrower to understand its fundamentals and then sensitise to see how covid-19 might impact future performance. At the same time, it has never been more difficult to do long-term planning. At the end of the first quarter, lenders and borrowers alike hit the pause button without taking much action. Towards the end of June, we started to see more normal borrower and lender discussions regarding distress. Now, I think there is pressure to address the most troubled credits.
In the more serious restructurings, how do you and your clients navigate through the various risks?
JR: The challenge is making sure you know what your client wants and figuring out how to accomplish that through the documentation you have. A key issue is what live opportunities exist, because the documents often leave many options. We have also encountered many situations that extend beyond the borrower versus lender relationship, as there are situations where one set of lenders could benefit themselves over other lenders under certain strategies.
MM: As an initial matter, it’s imperative to understand all documents governing a distressed situation and the various leverage points of each of the stakeholders. Knowing your client’s strengths and weaknesses vis-à-vis the borrower and vis-à-vis other lenders is critical. Further, it is essential to be proactive and be prepared to address all contingencies.
What has been the impact of EBITDA add-backs? Are there any other specific covid-related terms that have entered deal structures or terms?
JH: The EBITDA definition is aggressive in deals and, in many deals, includes an add-back for cash and non-cash extraordinary non-recurring and unusual costs, expenses and losses. Those terms should be determined in accordance with GAAP principles and should not permit an addback for things like lost revenues. It is possible that borrowers will try to interpret them more loosely to fit their needs in the pandemic, but we have not seen a lot of that yet. If there is also an add-back for lost revenue that could be a potential problem for lenders. We could potentially see borrowers asking for more pandemic-related add-backs, as seen in a small number of public deals in the last month or two.
JY: Clients today are asking us to determine how they can get out of a credit before they get into it. Experience is not a governor of what will happen in the future, so we are seeing scenario planning based not on the last recession, or on 30 years of direct lending, but on mapping all the different scenarios that could happen and making projections. Clients are thinking through all of that before going into deals now.
Are there any cross-border deals closing? What about cross-border restructurings?
MM: While cross-border deals have slowed, the fact that institutional banks appear to be pulling back in Europe may create an opportunity for non-bank lenders. As for cross-border restructurings, we have seen a number over the last six months, including several in the airline industry, oil and gas, and retail.
JH: We have noticed that banks have pulled back from some of the international lending and deals with significant international components, so non-bank lenders will be able to step up. That is a tougher underwriting process for lenders, but we expect to see more of it in Q4 and next year.