The burgeoning private debt funds industry faces a few hiccups, warns Ashurst partner Mark Vickers.
One of the prominent features of the private debt market in leveraged lending in the last 12 months has been the gathering momentum of credit funds.
In 2007, European leveraged loan issuance maxed out at €220 billion; in the year just completed, new European leverage lending was a mere 12 per cent of that peak – at €27 billion.
As many lenders, (in hindsight now styled ‘traditional lenders’) grapple with capital constraints, restrictive regulatory change and legacy stigmas associated with historic exposure to leveraged finance, the liquidity gap is being filled by alternative credit providers.
The European high yield market has had a blistering run over the last year, fuelled by over €29 billion of inflows and below average default rates (indeed the asset class outperformed US high yield and emerging market bonds over the last 12 months). And encouragingly, the green shoots of a renaissance in the CLO market may also be emerging.
However, of all the sources of alternative debt funding, it is the credit funds area which is the fastest evolving sector.
The new community of credit funds is diverse – including traditional heavyweights such as ICG, Apollo, GSO, Carlyle, Oaktree, Ares, Fortress, Sankaty, Babson and Haymarket Financial among others. There are now upwards of 40 credit funds focussing on mid-market leverage finance, including Summit, Triton, Butler Capital, Prefequity, to name but a few, with new entrants entering all the time such as 3i alumni Jonathan Russell and Andrew Golding’s Spire Partners, announced last month.
A vexed question is how the new world of credit funds is likely to perform in the short term, until the supply-demand equilibrium for mid-market debt comes closer into alignment. The proliferation of funds, and the paucity of good quality credits is, for the time being, making it difficult for the funds to deploy their capital. At the upper end of the mid-market the issue is being compounded by the burgeoning high yield market, and its encroachment into a domain hitherto seen as too small in terms of deal size for high yield.
Alternative debt providers are seen as having a stronger appetite for risk compared to the more conservative traditional bank lenders, with a more flexible approach to the credit requirement of specific deals. The preponderance of unitranche deals for example have bullet repayments after five to eight years with covenant-lite protection.
In this lean deal environment, it is difficult for new entrants with no direct track record to compete: unless a fund has an ‘edge’, the competitive drivers in winning deal mandates become quantum of debt and price.
There is evidence that leverage ratios are trending upwards, margins are trending downwards and covenants are becoming looser. Credit funds are not adverse to lending up to 6.75 times EBITDA in appropriate cases, whereas traditional banks are more comfortable with a senior structure typically around 4.5 times, with mezzanine taking leverage to 6.5 times. Margins on senior A were 4.5-5 percent six months ago; now 4-4.25 percent is not unusual. It is not surprising, therefore, that at least nine sizeable transactions completed in the last six months by major sponsors are looking to re-price by reducing the margins on their existing leverage loans.
Competitive pressures on credit funds to do deals may in the short term nudge them to complete by stretching debt fundamentals. These are the growing pains of an assertive, dynamic and innovative market, but only the unwise would ignore the lessons of the bad behaviour of 2007. The proper pricing of risk, and not just a search for yield, is still a premium skill. n
Mark Vickers is a partner in the banking department at London-headquartered law firm Ashurst, and is co-head of banking strategy.