Sorry to burst your bubble

An undeniably frothy private credit market makes for precarious times: it’s never been better to be a private debt manager but there are plenty of signs pointing to an over-exuberant market.

I’d like to think Oaktree Capital Management co-chairman Howard Marks read some of Private Debt Investor’s recent coverage before penning his latest memo, “There They Go Again… Again”, in which he addresses many of the same alarming factors market sources continually tell PDI. But given that Marks cites old writings, he beat us to the punch.

In the memo, Marks lays out the factors that could cause a bull market, boom or a bubble, and many are apparent to private debt investors. Data and PDI’s daily conversations with a cross section of sources point to one conclusion: the high probability of a private debt bubble.

One factor Marks cites in identifying a bubble is “the pursuit of the new”, in which managers flock to an asset class or strategy and “the gains go disproportionately” to the fresh faces.

This trend has turned up in PDI’s in-house data – this month we reported there are 528 private debt vehicles fundraising, the most in market at any given point. In addition, advisory firm bfinance noted 27 percent of senior debt funds in recent fundraising searches were first-time senior debt funds. Many debut vehicles consistently raise hundreds of millions of dollars.

Additionally, Marks’s principle of “more money than ideas” can point to a bubble. PDI’s fundraising statistics show a near-record amount of money collected for the first half of the year, with $61.59 billion raised across 67 funds that held a final close, the second most for an H1 since 2010.

The Oaktree figurehead also prescribes a “rejection of valuation norms” as something that can signal a bubble.

Purchase price multiples for mid-market leveraged buyouts in the first half of the year stood at 9.4x, while broadly syndicated LBOs were 10.3x, according to Thomson Reuters data through June.

While broadly syndicated LBOs are a half-turn below their pre-financial crisis high, the mid-market purchase price multiples are slightly up from 2007 and 2008 numbers, which stood at roughly 9.2x and 9.1x, respectively.

One deal pointed out to PDI was going for an enterprise-value multiple in the high teens.

Debt-to-EBITDA and equity contribution ratios in LBOs are also key indicators for private credit. Mid-market debt-to-EBITDA LBO ratios were 6.15x in the second quarter, the third-highest quarterly level since the Great Recession. The same figure for LBOs that were broadly syndicated was 6.4x.

One well-positioned source told PDI some deals run through the auction process have had an equity commitment as low as 30 percent. The Thomson Reuters average for mid-market and broadly syndicated deals are 14 and 10 points higher, respectively, but given the deterioration of deal terms it wouldn’t be surprising if those averages work their way down.

In his memo from February 2007, Marks notes capital can’t be differentiated except for in pricing. “Everyone’s money is pretty much the same,” he writes. “So if you want to place more money – that is, get people to go to you instead of your competitors for their financing – you have to make your money cheaper.”

This has particularly happened as of late, the Thomson Reuters numbers show mid-market first lien loan spreads have fallen around 1.75 percent since early 2016 to 4.92 percent, as of the end of the second quarter.

Another way fund managers can differentiate themselves other than pricing is through covenants, which now often contain aggressive EBITDA addback provisions and have “free and clear baskets”, or the ability to borrow a certain amount without being subject to leverage ratio tests, that offer significant latitude.

Marks is careful to point out that he does not come to the conclusion that credit investing is risky, private equity commitments won’t pan out or that we have entered a “nonsensical bubble”. Rather, Marks concludes, “the temperature is elevated”. 

That elevated temperature certainly applies to private debt, even if we haven’t reached bubble territory just yet.