State of the market

Private credit has come a long way in a short space of time. But how are increasing fund sizes, more flexible terms and the prospect of a more difficult economic environment shaping the way managers are approaching the market?

This article is sponsored by Proskauer.

The past five years have seen the private credit market develop at an astonishing pace as institutional investors have shifted increasing amounts of capital towards direct lending strategies. With nearly $135 billion raised globally in 2018, according to Private Debt Investor data, private credit funds are now an established part of the deal financing landscape, with the capacity to offer borrowers flexibility and an increasing array of sophisticated products that enable them to pursue their strategies.

Steven Ellis

The record sums now managed by private credit firms has led to a marked increase in the size of deal many players target. Much of the $36 billion that Ares Management Corp attracted during 2018, for example, was raised for its credit strategies, while ICG raised €6 billion last year to bring its total AUM to over €33 billion, and GSO Capital Partners’ third Capital Solutions Fund raised $7 billion in 2018.

And these firms are far from alone in being able to raise multi-billion-dollar funds. While just a few years ago, private credit was largely a mid-market strategy, funds are increasingly looking at larger deals and are holding ever larger ticket sizes in a bid to deploy capital. BlueBay Asset Management’s latest €2.5 billion Direct Lending Fund, for example, is targeting European borrowers with enterprise values of up to €2 billion and is seeking to underwrite transaction sizes of up to €300 million, with a hold of up to €150 million, while Ares’ hold size is up to around €300 million in its $6.4 billion joint venture direct lending programme with Varagon Capital Partners. In fact, the private credit market has developed to such a stage that it is now a viable alternative to high-yield bonds in some instances, offering not just the quantum, but also similar flexibility and a greater degree of certainty of financing for borrowers.

Of course, targeting larger deals enables credit firms to invest the sizeable amounts of capital they need to deploy. Yet this trend also reflects the fact that direct lenders have become far more selective in the companies they back at a time when many believe we are reaching the top of the credit cycle. Larger companies offer lenders greater stability and lower risk and they are often run by better quality management teams.

“Given how competitive the credit market has now become, firms are faced with the choice of either staying out of the market or offering the flexible terms that borrowers and their sponsors now expect”

Given how competitive the credit market has now become, firms are faced with the choice of either staying out of the market – a strategy that would not be welcomed by their investors, which have committed capital on the basis that it will be deployed within the investment period – or offering the flexible terms that borrowers and their sponsors now expect.

Yet to do this, direct lenders are taking a more conservative approach to the businesses they lend to, with an eye on a potential softening of the economy at some point over the next two to three years. This is perfectly in step with the way sponsors also see the market – what we’re seeing from both direct lenders and private equity firms (which also have record amounts of capital to deploy) is portfolio construction designed to deliver returns across all companies rather than home runs. Bolt-on acquisitions are a clear feature of the market today and over the coming year or two, we may well see direct lenders increasingly finance dividend recaps – which accounted for just 12 percent of the 188 completed deals we analysed in 2018 for our latest Private Credit Insights publication – in a bid to deliver the returns their investors expect. This trend may accelerate as sponsors seek ways of returning capital to investors in the event that the exit market slows.

A hands-on approach

A potential shift away from the benign economic environment we’ve seen over the past few years is also concentrating minds at the helm of many direct lending funds. Over the past 18-24 months, we’ve seen an increasing focus in the industry on portfolio management capability. Firms may have different models – some houses have a preference for origination teams to retain portfolio management responsibilities post-transaction, while others keep the two functions separate – but there has been a clear move towards bringing in more portfolio management expertise to ensure their positions are protected in the event of underperformance.

“Firms may have different models but there has been a clear move towards bringing in more portfolio management expertise to ensure their positions are protected in the event of underperformance”

This latter point is especially pertinent in today’s market, given the looser terms on which many lenders have advanced capital. Cov-lite and cov-loose terms in particular have become increasingly prevalent: only 60 percent of deals in our Private Credit Insights report featured traditional financial covenants in their documentation. Credit funds are therefore highly cognisant of the fact that companies will be able to trade for far longer than has historically been the case before any loan covenant is triggered. As a result, funds are monitoring their portfolios closely to ensure they can work with companies effectively and flexibly in the event of a downturn.

Yet while documentation has enabled greater flexibility for borrowers, the past few months have seen something of a pullback on the part of lenders to close loopholes and prevent companies from exploiting certain provisions in ways that were unintended when agreements were initially negotiated.

The case of J Crew, in which the company created an unrestricted subsidiary to hold its intellectual property for use as collateral against which it subsequently increased its borrowing, and similar instances involving other businesses, have focused minds on areas of sensitivity. In particular, we’ve seen far more careful consideration of incurrence test and leakage terms by credit funds. For their part, sponsors have also been largely supportive of loopholes being closed, so that, as we move through 2019, the market as a whole is attending to documentation in a more robust manner while still offering the flexibility that borrowers need to grow and navigate a potentially more difficult market.

Overall, the stage is set for continued direct lending activity as both credit funds and private equity sponsors need to deploy the capital they have raised. Yet the focus is on larger, stable businesses with strong management teams and in areas of the economy most likely to trade well through any economic downturn. There is an element of caution to the market as funds take into account headwinds such as the effect of trade tariffs, Brexit and volatile stock markets, but we are not seeing hesitancy. For the right deal, with the right management backed by the right sponsors, direct lenders continue to put their money where their mouths are.

Steven Ellis is a partner in the corporate department, co-head of the Private Credit Group and a member of the executive committee at Proskauer.