‘Pockets of crazy’ was what one credit fund manager, speaking at a panel at the Private Debt Investor Forum in New York in mid-September, called the cropping up of covenant-light loans and rumours about lending standards deteriorating. While the general mood and buzz around the conference, and seemingly in the industry overall, was thoroughly optimistic, debt fund managers, alternative lenders and BDCs did say they were concerned about a number of things: further erosion of lender discipline, the fact that some of this looks unnervingly similar to pre-market-crash 2007-2008 excesses, uncertainty about bank regulation and potentially too many new entrants in the private debt market.
Everyone agreed that there was plenty to feel good about, too: a flurry of deals being made, more institutional investors putting money in the sector (and actually starting to make formal allocations to private debt as an asset class). While regulatory uncertainty continues to hang over the industry, further restrictions on bank lending could be a boon to private debt funds, which will stand to gain from any activity banks would have to shed.
At the same time, though, the pile of potential opportunities is attracting newcomers eager to get in on the action, and some established lenders worry that many of these might not be well-versed or skilled enough in the debt game to pick the right deals, or gobble up undue risk and unsafe loans in order to get their feet in the door. For now, it looks as though most of the cov-lite deals in the US are limited to the broadly syndicated loan market, where holders of a small piece of a large loan are largely protected from risks because of their limited participation in the deal.
However, some worry that cov-lite could spread to parts of the direct lending activity. “There are certainly some execution and deal terms out there that make us scratch our heads,” one lender told the conference. But there was also a consensus that the risk of default and credit losses was still low – or at least lower than in 2007 – and that it’s more likely for an unpredictable systemic event to wreak havoc on the market than a deterioration in lending standards. Covenant-light loan volume recently reached $83.6 billion over 82 deals in the first half of 2014: a 41 percent increase from the same period in 2013 ($59.4 billion over 68 deals), according to Dealogic.
As the private debt industry carries on growing and capital continues to pile in, the big question facing lenders is about good old-fashioned credit quality: faced with ever-greater competitive pressure, will they be careful and disciplined enough to side-step the dicey deals and companies?
Unsurprisingly, a lot of the debate at the PDI Forum revolved around grilling debt providers on how they pick their deals and portfolio companies, how they avoid risk, how they monitor their loan books, and so on. Resources are certainly a factor here. The large, long-established lenders have their own origination teams, well- staffed and often the heaviest cost on their business. Many of them sift through hundreds of deals per year, but wind up investing in only a fraction. It seems plausible that these houses are indeed being careful enough. And as long as the ‘pockets of crazy’ don’t turn into ‘crazy pants’, the risk of industry-wide calamity still seems low.
“We expect the environment to remain relatively benign for the next couple of years,” said KKR’s co-head of leveraged credit Erik Falk. But again, a flurry of new entrants has the power to change this. It is advised that everyone – rookies and old hands alike – tread carefully.
Forthcoming PDI events are the Capital Structure Forum 2014 on 28-29 October in London, and the China Corporate Debt Forum 2014 on 6-7 November in Hong Kong. For details, visit www.privatedebtinvestor.com.