For two days in late September, the who’s who of the private debt world packed a Midtown Manhattan conference hall for the fourth annual PDI New York Forum. On stage, in the lunch line and around the coffee tables, conversations all circled around how and why limited partners use the asset class in their portfolios, the possibility of a downturn in the credit markets or global economy and the proliferation of covenant-lite transactions. Here are some of the top takeaways:
Luring investors from private equity
The Policemen’s Annuity and Benefit Fund of Chicago is in the market to replace its entire private equity portfolio with private debt, which will be more beneficial to the pension fund’s cashflow, chief investment officer Aoifinn Devitt said during a panel.
Other pension funds have also decided to lean towards private debt over private equity, including the Arizona State Retirement System and Arizona Public Safety Personnel Retirement System, which now have larger allocations to private credit.
The sentiment lined up with findings from Willis Towers Watson’s Global Alternatives Survey 2017, published in July, which found that illiquid credit assets under management rose quicker than any other alternative asset class – up more than 100 percent year-on-year, year-end 2016, from $178 billion to $360 billion globally.
In addition, highly leveraged buyout purchase-price multiples have caused some clients to shift away from private equity, Tod Trabocco, managing director and co-head of the credit group at global investment consultancy Cambridge Associates, told attendees.
To put some numbers behind that sentiment, LBOs in the top quartile of the private equity market are currently priced higher than pre-financial crisis levels, at a “scary” 14.9 percent premium, according to Christopher Godfrey, senior partner at analysis firm CEPRES.
Private debt as a defensive investment
Private debt performance over the last 10 or so years suggests the asset class is a good hedge against a looming downturn, Godfrey said during his data presentation.
Though returns on private equity buyouts outperformed private debt deals during boom years, the figures for each asset class converge during down years. In 2009 private debt showed some of its best returns even though very few deals were completed that year. “Private debt has shown to be counter-cyclical over the years,” he concluded.
The asset class has shown relatively lower volatility than other investment strategies like private equity, agreed Stephen Nesbitt, chief executive at advisory firm Cliffwater. He noted that in the thick of the financial crisis private credit drawdowns were at a minimal 10 percent.
Now, more investors are attracted to the low volatility of the asset class, he added. “Clients used to ‘poo-poo’ it,” Nesbitt said, “but today … it’s graduating.”
Nesbitt’s firm developed the Cliffwater Direct Lending Index, which tracks US corporate mid-market lending using business development companies’ returns as a proxy. The index’s latest report showed it returned 10.41 percent for the 12 months ending 30 June.
Covenant-lite transactions run amok
Deal documentation has become more borrower-friendly today than 10 years ago, only months before the global financial crisis hit, David Golub, president of Golub Capital Partners and chief executive of Golub Capital BDC, said in an interview with Wells Fargo Securities managing director Jonathan Bock.
“We’re seeing fake covenants,” Golub observed. “If a covenant has a definition of EBITDA that basically says management can add any amount of EBITDA as a cost-saving going forward, achieved over some period of time, how is that ever enforceable?”
Panellists agreed that the sponsor market has become significantly overheated. Henry D’Alessandro, managing director and chief investment officer at Morgan Stanley Credit Partners, voiced a preference for deals without a private equity sponsor, saying the investment bank’s private debt deal pipeline is almost exclusively non-sponsored transactions.
Jon Marotta, a managing director at Crescent Capital Group’s mezzanine practice, added that the credit world at one point could have been divided into the “haves” and “have-nots” – or those that could access the capital markets and those that couldn’t. Amid frothier markets, some companies are landing debt investments that in tamer markets might have been out of reach.
Golub also noted he has seen dramatic worsening of terms in smaller deals. In 2007, covenant-lite deals were mostly in the broadly syndicated loan space, he explained, but covenant-lite deals as small as $40 million are getting done.
Covenant-lite deals may be moving even further down market, though, with one source recently highlighting such a transaction involving a golf course developer with an EBITDA of around $25 million.
Assessing managers by zeroing in on deals
Oliver Fadly, a senior research analyst at advisory firm NEPC, told attendees that LPs should ask private debt managers about their deals. More specifically, Blair Jacobson, Ares Management’s co-head of European credit, said LPs should ask about the managers’ restructuring and workout processes.
Managers won’t get every transaction right, so the effort involved in a workout is key to recouping as much money as possible on an investment, as well as winning support from investors. Devitt, the Policemen’s Annuity and Benefit Fund of Chicago’s chief investment officer, noted that managers which are intricately involved in salvaging their investments are often the firms that show integrity.
New York Forum attendees also saw a presentation on what successfully rescuing a good deal gone bad looks like. Joe Lazewski of NXT Capital presented his firm’s investment in Coyne International Enterprises.
NXT provided the Syracuse, New York-based laundry service and uniform rental company a loan with 3.25x leverage. After negotiating a forbearance along with unsuccessful efforts to refinance the loan and sell the company, NXT backed Coyne with a debtor-in-possession financing as it moved through the Chapter 11 process, which the company initiated in July 2015, according to bankruptcy court papers.
NXT teamed with Coyne’s senior management team to provide a stalking-horse bid for a majority of the company’s assets, while two strategic buyers made offers on specific locations and customer routes. The assets ultimately went for more than the stalking-horse bids and NXT received cash consideration that exceeded its secured claim.
Fund managers and LPs may have left the conference with a tinge of anxiety after swapping war stories and market observations, but it was clear private credit has not only matured into its own distinct asset class but has also performed well, relative to public markets, in good times and bad.