Private debt sails into uncharted waters

If you’re a large manager with freshly raised capital, you may be poised to prosper. For others, things could be about to get more challenging. PDI examines the landscape for private debt following the recent banking woes.

With regional and other banks licking their wounds after the blow-ups at Silicon Valley Bank, Signature Bank and Credit Suisse, to say nothing of the near collapse of First Republic and the troubles at Deutsche Bank, it would be easy to assume that a wealth of opportunity awaits private lenders.

But not all private lenders are created equal, and the result of the recent turmoil is likely to be somewhat more Darwinian – at least in the US market – while in Europe and the UK, where private debt is still relatively young and banks are becoming increasingly cautious, opportunities may be more straightforward.

To be sure, bank regulations may tighten further, given the willingness of the US Treasury and central bank to ensure that positively no one gets hurt by financial mismanagement – except perhaps US taxpayers. And banks themselves likely will pull in their horns amid a weakening economy and rising defaults and bankruptcies.

While many private debt managers should benefit from the bank pullback – especially those with fresh capital – they won’t be immune to the increased scrutiny, nor will they escape banks’ growing skittishness about extending credit to asset managers themselves. The well-heeled titans, including the top 10 private debt managers who control nearly one-third of the $1.2 trillion direct lending market, and the nimbler veterans who have been through a credit cycle or two, are well positioned to gain from the continued market turbulence, and to take share from banks and other competitors. Their smaller, weaker and more inexperienced brethren, however, could be in for a rather rough ride.

That’s because of the belief that US private credit is about to experience its first really big test. “Unfortunately, it appears we’re headed for a slow-moving train wreck,” says Ivan Zinn, founding partner and chief investment officer of fund manager Atalaya Capital Management. “Investors are going to expect to make higher returns, and it’s going to take time to figure out who is able to manage through workouts, who had a backup plan, and who was underwriting downside cases.”

The main issue is that “the secularly declining interest rate environment that we have been in since 1981 is over”, says Ken Wiles, clinical professor of finance at the University of Texas. Not only is the US Federal Reserve engaging in the fastest and most significant interest rate increases ever, but unlike other periods of tightening, it isn’t just short-term rates the Fed is driving up, but medium and long-term rates as well.

The upshot? “Near-term it means that long-duration assets become much less attractive, and private capital investments in both private equity and venture capital, financed by private debt, are long-duration assets,” he says. “If you’re an institutional investor, you can hit your 7-8 percent returns without tying up your money.”

Although opportunities will abound in private credit for those with fresh capital, portfolio companies of managers who can’t raise new capital will be under “tremendous pressure” and will have to look elsewhere for new funding, says Wiles, who is also executive director of UT’s private equity centre. Already, fundraising has slowed, and Wiles says the fallout from the current situation could be similar to 2000 and 2001, when many private capital funds, particularly the smaller ones, couldn’t raise the next fund.

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Moreover, banking system disruption likely will continue to constrain fund managers’ access to the subscription lending market – which constituted a major part of the loan books of SVB and Signature Bank – and which helps boost funds’ IRRs. More private mid-market fund managers chasing fewer dollars in the $500 billion-plus market has created “the perfect storm” for subscription financing, says Zachary Barnett, a co-founder of Fund Finance Partners, a debt adviser to private funds.

The SVB and Signature defaults coupled with remaining banks in the space facing increased regulatory capital restrictions for 2023 will mean that even mega-fund managers will likely have trouble accessing the subscription facility sizes they desire. But the lower mid-market managers that have raised several hundred-million-dollar funds are likely to be hardest hit, as the lack of supply may render them without a facility altogether. Pricing for these loans has widened as much as 100-plus basis points compared with last year.

Meanwhile, portfolio company valuations are declining, reducing debt service coverage, even as M&A activity and exits languish. William Cox, global head of corporate, financial and government ratings at KBRA, concluded after publishing a report last autumn that “roughly 16 percent of the 1,900 (non-investment grade companies the firm evaluates for creditworthiness) that were previously able to cover interest from current cashflow will need to be supported in an alternative way” in the higher-rate environment. And that’s before the effect of downward recessionary pressures on revenues and upward inflationary pressures on costs. Cox expects the total impact of increased interest costs to manifest in the latter part of the second quarter.

Furthermore, the KBRA report predicted that unlike during the pandemic, standard “amend and extend” and equity infusions may be insufficient if borrowers find higher rates unaffordable. “The most interesting dynamic will be between lenders and sponsors over the next couple of months,” Cox said more recently, given the inevitable failure of some companies and the sheer number of companies “where it isn’t obvious what to do” and where senior secured lenders have the upper hand.

Bankruptcy filings by private equity portfolio companies surged in the first month and a half of this year, and at the current pace could more than double the totals of the past two years and reach the second-highest number in more than a dozen, according to S&P Global Market Intelligence.

Former Kansas City Fed president and vice-chair of the FDIC, Thomas Hoenig, warned in a Wall Street Journal interview in mid-March that assets like mortgage-backed securities and those in the already-moribund market for collateralised loan obligations, which hold significant amounts of leveraged loans that finance buyouts, can become a weakness on bank balance sheets in a recession.

“There will be hundreds of billions of dollars of opportunity created by banks tightening their appetite for commercial and industrial lending,” says Darius Mozaffarian, president of White Oak Global Advisors.

Paul Goldschmid, a partner at King Street Capital Management, believes that “the coming decade will be the decade for credit, especially providing much needed capital to the $1.7 trillion levered loan market that is approximately 70 percent-owned by CLOs”. In that market, the firm is finding deals of SOFR plus 1,000 basis points. “As bank deposits decline, certain banks may be forced to pull back on lending or sell their less-liquid assets, including their massive commercial real estate exposure.”

Deal drop

Deal volume in the commercial mortgage market was tanking even before the banking turmoil. MSCI Capital reported a 51 percent drop through February from the like period in 2022, with office transactions sinking 66 percent. A total of nearly $900 billion of CRE loans is set to mature this year and next, the report says, with CMBS, CLOs and investor-driven lenders accounting for more than $400 billion of loans coming due this year alone.

Given the higher returns available in the public credit markets, private managers, which formerly could get away with 7 or 8 percent returns, now will need to achieve 10 percent returns to compensate investors for the illiquidity risk.

Already, investors are beginning to balk. In late March, the investment management committee of Marin County Employees’ Retirement Association rejected what is usually a rubber-stamp approval for a term extension request from Abbott Capital Management for one of its flagship fund of funds. The previous month, Alaska Permanent Fund’s CIO, Marcus Frampton, who said late last year that he is as “bearish on private equity” as he ever was in his career, proposed to cut the fund’s targeted allocation to private equity by 1 percent a year in each of the next two years.

Unsurprisingly, credit secondaries trades are on the rise, hitting $17 billion in 2022, more than 30 times the total volume 10 years earlier, according to secondaries firm Coller Capital. In recent months, Apollo Global Management and Ares Management, along with Mubadala Investment Company, have bolstered their secondaries’ businesses. Big banks, including Goldman Sachs, JPMorgan and Barclays, are also reportedly looking into the secondary debt market.

While the global financial crisis was characterised by problems with consumer loans, this time around corporate debt, some of which has been poorly underwritten during the heyday of easy money, seems poised for what one manager calls “a huge blowup”.

Today, more flexible, opportunistic managers who are able to raise new money and who have focused on the downside and are capable of doing workouts, will fare better. But it seems inevitable, as Atalaya’s Zinn says, that “there will be a culling of the herd”.

Meanwhile, Europe today faces some of its most difficult days in more than 70 years with inflation hitting double digits, rapidly rising energy costs hitting consumers and industry hard, and war in the far east of the continent that threatens geopolitical stability that hasn’t been seen since the USSR collapsed.

As if this weren’t enough, contagion from the collapse of regional banks in the US led to the Swiss government arranging a hasty takeover of Credit Suisse by its rival UBS and has also once again sparked fears over other European banks, including Deutsche Bank.

Fresh opportunities

With so many major headwinds, it seems hard, nigh impossible to be bullish on European business prospects. But for private credit funds, this fresh instability for the banking sector could once again provide opportunities for the asset class to go through a boom as it did in the years following the global financial crisis in 2008.

“The recent trend in Europe has seen market share moving towards non-bank lenders, but it has been uneven and a lot slower in countries like France and Germany,” says Michael Curtis, head of private credit strategies at Fidelity International. “However, recent events with the failure of SVB and other instability within the banking system will accelerate that process.”

He explains that much of the regulatory regime that has been introduced in Europe since the 2008 crisis has been aimed at disincentivising banks from lending to mid-market companies and reducing their credit risk exposure, though they have continued to lend to mid-market firms despite this, albeit in a much-reduced capacity.

“Regulators want banks to be less exposed to credit risk and see that risk spread across many more banks, insurers, pensions and sovereign wealth funds,” Curtis adds.

While the fall of Silicon Valley Bank, which prompted this mini crisis, has been felt most acutely in the US, the firm did operate in several countries around Europe, and there remain a lot of unknowns about how this will play out. While the UK arm of the business was quickly acquired by HSBC, the firm also had substantial reach into Germany and Israel as a lender to growth firms, and those businesses remain subject to the Chapter 11 bankruptcy proceedings in the US.

“SVB was a major lower-cost player in growth financing in Europe,” says Ross Ahlgren, co-founding partner at European growth lender Kreos Capital. “It really was a unique animal in that it could bank on both sides of the Atlantic and provide deposits, loans and credit cards for growth businesses so it’s a big loss for the ecosystem.”

Crucially, while SVB was involved in making loans to growth capital firms that are often viewed as high risk, that loan book was not the reason for its failure, which was largely caused by the management of its balance sheet and the impact of rising interest rates. For private lenders active in the part of the market where SVB operated, there is now an opportunity to pick up new business and firms, which have solid fundamentals but likely face liquidity issues in the wake of SVB’s demise.

But it’s not just growth capital that is likely to see a crunch in the coming years. While much regulatory energy has been expended in making sure that large, systemically important banks are well capitalised and capable of withstanding volatility, there has been less focus on the risks inside regional banks. While some countries in Europe, such as the UK, have little regional banking, others like Germany, France and those in Southern Europe still have extensive and active regional bank networks. For firms operating in the mid-market, these have typically been the first port of call to meet their liquidity needs.

If regulators do increase their focus on regional banks then this is likely to lead to further retrenchment and drive more mid-market firms to seek out alternative forms of financing. However, the private credit market in Europe only has so much capacity to absorb business that would previously have been financed by the banks, and the big question today is do institutional investors and their GPs have the capability and the appetite to step into that role the banks once occupied?

Curtis believes they do: “The market has always found solutions to market problems and will do so again this time.”

Reward for incumbents

In the wake of the GFC, private credit expanded in Europe from being a tiny niche to being a key player in mid-market financing and saw a proliferation of new firms coming to market. But this next stage in the industry’s development is unlikely to see an increase in the number of firms active in this market but instead reward the biggest, strongest players already here today.

“While we could see new managers coming to the market, it’s very difficult to build a credible direct lending platform today,” says Curtis. “We’re building out our own but we have the benefit of having a lot of resources being part of a larger group; for independents it will be much harder.”

There has been a level of excitement among private credit managers in recent years as events such as the covid-19 pandemic and now the prospect of a fresh wave of bank regulation create market disruption that will ultimately be beneficial for firms. Unlike the US, European private credit still has a lot of room to grow over the coming years and become one of the major sources of liquidity for mid-market firms.

However, the market is also far more developed than it was in the early 2010s when the first private credit boom began. LPs have more experience of the asset class and will be looking for firms with a demonstrable track record and the scale to originate and underwrite deals of varying size in a wide variety of sectors and geographies. Recent years have the seen the big firms getting even bigger and the second banking crisis is likely to accelerate that trend.

 

One failed bank and two bifurcations

The failure of Silicon Valley Bank, and the uncertain fate of other members of the SVB family, has excited parts of the venture debt world, though it has left others cold

 

Zack Ellison, founder and managing partner of fund manager Applied Real Intelligence, expresses a common view. He tells PDI that ARI is positioned for “what we believe will be the most attractive vintage years in the history of venture debt financing” due to the imbalance between the supply of venture credit and the demand for it.

However, David Spreng, CEO and CIO of San Francisco-based fund manager Runway Growth Capital, does not believe that the failure of SVB bears upon Runway’s prospects at all.

“Most of the impact was on the world of early-stage venture capital and credit,” he says, and has little consequence for the business of Runway, making $10 million to $100 million loans to late-stage pre-profit companies.

There is another bifurcation that becomes clear as one studies the venture debt world today: crypto assets.

Silicon Valley Bank as a lender was somewhat wary of crypto. According to one crypto investor (quoted in the New York Times): “A lot of crypto start-ups had a very hard time on-boarding onto Silicon Valley Bank.”

That said, crypto companies did keep cash there. On 12 March, two days after the bank’s closure, Brad Garlinghouse, chief executive at Ripple Labs, a crypto-oriented tech company in San Francisco, tweeted an acknowledgement that SVB was a “banking partner [of Ripple] and held some of our cash balance”.

There are those in Silicon Valley who believe that crypto assets and blockchain constitute the wave of the future. There are also those who would distance themselves with the proverbial 10-foot pole.

On the one hand: Silvergate and Signature Bank, the other bank failures of March 2023, failed in large part due to recent disruptions in the crypto markets. Between them they were the two main banks for crypto companies.

On the other: Ted Koenig, chairman and CEO of fund manager Monroe Capital in Chicago, says: “We [at Monroe] have zero exposure to that industry.” Crypto, he added, “is not an industry that we are comfortable with”.

Monroe is an important player in the world of venture debt for tech, especially since its acquisition of Horizon Technology Finance in February. Its lack of “comfort” with crypto is not at all unusual there.