PDI New York Forum takeaway: Don’t look down

One conference attendee noted rising scepticism about private credit and the crowded market among those that have been involved in the asset class for a ‘meaningful amount of time’.

At Private Debt Investor’s annual New York Forum, there was an air of uncertainty about private credit; investors are still eager to commit capital to the asset class, even as private credit managers voiced concern over the frothy market.

The situation presented those involved in private debt with a dichotomy: limited partners want to allocate even more capital to asset class, all while large-cap and upper mid-market deal terms continue to be pulled down-market, making mid-market lending riskier. And there may be only two ways out of it.

The Policemen’s Annuity and Benefit Fund of Chicago is one of the LPs that has made the case for the asset class. Aiofinn Devitt, chief investment officer of the pension fund, said that the pension fund is marketing its private equity investments, all of which are legacy positions, and will focus on private credit.

The PABF has upped its allocation to the asset class in the past year, as Devitt said the pension fund is underfunded and must generate cashflow. With quarterly distributions, private credit is better suited to fill those needs than private equity.

The Chicago retirement plan is not unique in increasing its exposure to private credit. Numerous pension funds around the US have added a private credit investment category to their portfolio structure, while others have added direct lending to their private equity or fixed-income buckets.

Pennsylvania Public School Employees’ Retirement System also recently upped its credit allocation from 9 percent to 11 percent, a move justified with the opportunities private debt presents. The Harrisburg-based pension plan has been a big backer of the asset class, often writing some of the larger cheques to commingled funds.

Of LPs responding to a summer survey by Coller Capital, 40 percent said they plan to up their allocation to private debt, while only 8 percent said they plan to decrease their allocation. The LPs were not just in North America. Those polled included investors based in Europe and the Asia-Pacific, which included the Middle East, according to the survey.

Tod Trabocco, managing director and co-head of the credit group at global investment consultant firm Cambridge Associates, said at the conference he has seen more of his clients shift away from private equity investments due to rising buyout multiples. “Some clients are looking at equity markets at a peak that is equivalent to the last peak… and saying ‘where will I be in five years?’” he added.

For fund managers, the $50 million-EBITDA mark once served as a bright red line that divided the transactions with more and less stringent terms. Deals over that threshold were more borrower friendly, and those below were more favourable to lenders. Now, that EBITDA benchmark has come down to $40 million and rather than a hard cutoff, it’s much more of a suggestion than a rule.

The sheer number of covenant-lite deals has increased, as well upping the risk in the system. At the end of July, some 72.7 percent of all outstanding leveraged loans were covenant-lite, a percentage that has likely only increased, according to S&P LCD data.

Covenants that carry teeth that let the lender enforce its rights aren’t the be-all, end-all, one panellist said.

Managers still have to ask the most basic question: why does this borrower have a reason to exist as a business? If the fundamentals of a company are flawed, a covenant will not protect the value of the investment during a downturn, or maybe even during a relatively benign credit environment.

The mid-market has become red hot, with lenders signing onto pieces of paper with companies posting wildly inflated EBIDTA that are difficult or nearly impossible to ascertain. This further inflates leverage levels when a reasonable EBITDA number is used to calculate the metric.

When all these EBITDA adjustments are stripped away, aggregate earnings are a whopping 23 percent lower, Wells Fargo managing director and analyst Jonathan Bock said on Wednesday.

Another source of heartburn for managers could be equity contributions, as a source said the upper mid-market leveraged buyout deals he has seen recently have all had a lower percentage of the deal be equity capital.

Jon Marotta, a managing director at Crescent Capital Group’s mezzanine practice, said that the credit world at one point could have been divided into the “haves” and “have-nots”. Now, more companies are accessing capital than would be able to do so under less exuberant conditions.

The optimistic investor, pessimistic manager dynamic can resolve itself in one of two ways, a second source that attended the conference told PDI. Either the LPs will turn off the “spray hose of capital”, or the deal market will continue to worsen. All the players that have been in the space for a “meaningful amount of time” have come to express scepticism about the asset class, the source said.

One theme the source noticed in the discussions was the increasing competition for smaller deals. More firms getting into the game, the lower mid-market is becoming more crowded and larger firms are moving down market.

Investors want more private credit in their portfolio and there are more mid-market lenders than one can keep track of, all leading to lower pricing and looser covenants. And who doesn’t love mid-market lending these days?

– Justin Slaughter contributed to this report.