PDI New York Forum: ‘Time to be on defence’

  ‘Fake covenants’ and other signs of woe in today’s credit market call for selective investing, said David Golub.  

Private credit firms’ portfolios have overall performed “quite well”, with spreads slightly better than 2007, David Golub, president of Golub Capital, said during his fireside chat at the PDI New York Forum last week

However, this bout of strong portfolio performance has also come alongside higher leverage levels and more borrower-friendly deal documentation than ten years ago, he added. The “most troubling” factor in the market today is the “whole new level of loosening of terms”, from questionable EBITDA adjustments or other covenants that offer little credit protection, Golub said.

“We’re seeing fake covenants,” he said. “If covenant has a definition of EBITDA that basically says management can add any amount of EBITDA as cost-saving going forward, achieved over some period of time, how is that ever enforceable?”

Golub said he sees the most dramatic worsening of terms in smaller deals. In 2007, ‘cov-lite’ deals were mostly in the broadly syndicated loan space, but now we’re seeing cov-light as small as $40 million.

“There was a better case for debt investing in smaller companies five years ago than today,” he said. “The credit risk of smaller companies are significantly underestimated today.”

On top of a general loosening of terms across the credit spectrum, junior debt occupies a specific corner of the credit market in which fund managers should be wary of potential losses, Golub added.

As new entrants have emerged and a “flood of money” has gone to existing players in the space the last two years, the mezzanine debt space has become worse with stretched leverage levels and pricing compression, Golub said. Today, many mezzanine deals have a 9-10 percent yield and a 5x-7.5x EBITDA attachment points. And at these levels, “in a downside, your recovery is unlikely to be good”, he said.

Golub also noted that fund managers on non-lead transactions do not receive the same diligence information about the creditworthiness of the borrower, adding risk to the market. Compared to managers that lead transactions, non-lead transaction participants receive a “selling memorandum designed to sell you on the prospects for this company”, he said.

In such an environment, Golub said smart fund managers should shy away from the syndicated loan market and focus on diversifying their portfolios. “It’s not time to think about where is the home run; it’s a time to be on defence,” he said.