It is easy to forget just how young private debt is as an asset class. The industry that exists today only emerged out of the ashes of the global financial crisis. Prior to the imposition of the Dodd Frank Act, bank lending still dwarfed private debt deployment in the US. In Europe, meanwhile, the asset class did not exist until the introduction of Basel II began to cause banks to be regulated into submission.

During the unprecedented bull run that followed, private credit has flourished. This has been particularly the case in the mid-market, where managers have proliferated as a protracted low interest rate environment has left investors craving yield.

Yet private credit is now facing the first real test of its existence, and the events of 2020 will be of crucial significance for the industry. The broad consensus is that, buoyed by extraordinary state stimulus packages, mid-market direct lending has fared well and is back on the right track.

“Private credit has benefitted from stable, patient capital structures and strong governance and support from private equity sponsors,” says David Ross, head of private credit at Northleaf. “This led to lower-than-projected default rates and ample liquidity through the covid-induced economic shutdown.”

“Everything has bounced back remarkably strongly”
Matthieu Delamaire

Of course, there has been variability depending on sectoral exposure. Some portfolios have required more firefighting than others. But Anthony Fobel, chief executive of Arcmont Asset Management, points out that private debt managers have generally steered clear of cyclical industries.

“There is far less exposure to travel, hospitality and other areas affected by covid than there is in the overall economy,” he says. “This is due to a selection bias at an individual asset level, as well as more thorough due diligence.

“The other real advantage we have over liquid markets is time – time for a business to take action to remedy the situation before you incur losses. If a loan trades down 30 percent in the public markets, you have taken that 30 percent hit. But although we need to mark to market, we don’t need to sell. That time benefit gives you a lot of protection.”

Furthermore, the mid-market has remained relatively disciplined when it comes to maintenance covenants, in comparison with liquid loan and high yield markets. Any covenant breaches have therefore triggered dialogue with sponsors and management teams, prompting remedial action.

Paul Johnson, partner and head of direct lending at Bridgepoint Credit, a division of PEI Media owner Bridgepoint Capital, says the ability to work closely with management has been the big positive that has emerged from the crisis.

“We are not an owner, but we are a stakeholder and we have been really impressed by management teams’ willingness to be open throughout this period,” says Johnson. “That quality of communication is very different to that which you would find in a broadly syndicated loan, where you have to go through an agent who may or may not respond to your queries. For what is essentially the same instrument, with probably the same LTV, you can access vastly superior information, and I think that is a positive attribute of the asset class.”

Benoît Durteste, chief investment officer at ICG, agrees and says the firm’s experience over the past year has been much more constructive than was the case during the GFC. “The prevalence of direct lending structures often involving a single lender with meaningful exposure, versus large and evolving syndicates, is likely to be the main explanation,” he says. “Direct lending is a source of stability in this market.”

Twin Brook Capital Partners’ founder and managing partner Trevor Clark adds that “the health in which private credit markets find themselves after a year like this is, quite simply, phenomenal, both in terms of the health of individual companies and the returns the asset class has produced”.

Fobel agrees: “One of the criticisms historically levelled at the private debt industry is that it only really came about after the last financial crisis and there have been concerns about how it would perform in a downturn. The answer appears, unequivocally, to be ‘very strongly’.”

Competition creep

Managers also appear bullish about the prospects for 2021. Although dealflow dipped dramatically during the second quarter of last year, the rebound has been pronounced.

“At the beginning of all this, the market was frozen,” says Matthieu Delamaire, founding partner of European private debt firm Kartesia. “It was like a rabbit in the headlights. But everything has bounced back remarkably strongly.”

“Dealflow was fairly anaemic through last summer but really came roaring back in the fourth quarter,” adds Clark. “Pacing has now normalised, and we expect 2021 dealflow to look similar to that of 2019.”

“Pacing has now normalised, and we expect 2021 dealflow to look similar to that of 2019”
Trevor Clark
Twin Brook Capital Partners

There are three categories of business emerging. The first comprises companies that have been heavily affected by lockdowns, such as those in the travel and hospitality sectors. These are deemed unfinanceable by mainstream mid-market funds, but are providing tremendous opportunities for the special situations funds that often sit alongside them.

The second category comprises those businesses that have come through the pandemic bruised but not broken. These companies are being backed, but only very selectively.

But it is the third category – those businesses that have proved themselves covid-resilient, or even beneficiaries of the pandemic – where there is the greatest concentration of activity. “It is only really those companies that have performed well through covid, demonstrating good growth and good free cashflow, that are in the market for new deals or refinancing,” says Eric Capp, partner and head of the UK, at Pemberton Asset Management.

The problem, of course, is that with only a select group of sectors and business models in play, competition for these covid winners is fierce.

On the one hand, banks’ withdrawal from the market has been accelerated. “The push towards reducing bank’s balance sheets continues,” Capp explains. “But those balance sheets have ballooned due to the government-backed support provided to companies during the pandemic.”

Fobel agrees: “Banks have been busy supporting existing businesses and have therefore had almost no ability to finance new deals. Initially, at least, the liquid markets were also shut. Private debt has benefitted from the fact that it has remained a reliable and available source of capital.”

Yet although banks may have been edged out of the picture, the level of appetite emanating from the private credit industry more than compensates. “For businesses that have been somewhat impacted by the pandemic, there has been margin improvement of anywhere between 25bps and 150bps with leverage multiples half a turn to a turn lower,” says Fobel. “But in sectors such as healthcare, e-commerce, online education and IT services, the prices private equity has been paying have, frankly, been eyewatering, and the financing packages that have gone along with that are similar, if not worse, to pre-covid.”

Meanwhile, according to Delamaire, intermediation has become more common in recent months, even at the lower end of the mid-market. “It has become normal for small and mid-cap businesses to appoint an intermediary in order to choose a financing partner,” he says.

However, Capp insists it is important to avoid the most heavily contested auctions: “Where you have a large number of private equity firms and debt funds involved, often for those most defensive businesses, we’ve seen increased pressure on debt margins, leverage levels, and valuation multiples.”

It is not all bad news, however. According to Randy Schwimmer, co-head of senior lending at Churchill Asset Management, increased purchase price multiples mean the equity-to-debt ratio is actually at a historical high, even while debt-to-EBITDA ratios have returned to pre-covid levels. Intense competition for these prized assets among private equity firms has also increased the prevalence of pre-emptive bids. Sponsors have been willing to move quickly and put a full price on the table to secure a deal.

“If you are doing that, you are not going to go out to a wide group of debt providers because of the risk of a leak that will lose you your competitive advantage,” says Johnson. “We are definitely seeing more processes where just two or three lenders are invited. Sometimes those lenders are asked to work together if all deliver and sometimes just one is picked. But the competition is strictly limited – just enough to keep you honest on terms.”

The case for non-sponsored deals

Private equity is a principal source of dealflow for the majority of mid-market direct lenders.

However, MGG Investment Group focuses on sponsorless deals. The firm’s managing director Daniel Leger believes that while government stimulus programmes and weak covenants may be disguising deeper problems in the sponsor-backed credit space, opportunities to finance growth opportunities in the non-sponsored lower mid-market – businesses with EBITDA below $40 million – are increasingly attractive, with spreads significantly wider than a year ago.

“In the private equity-backed market, spreads have gone back to pre-covid levels – or worse – and while there was a brief window last summer when covenants got tighter, that has now passed,” Leger says. “There is a bidding war for every loan, resulting in borrower-friendly terms, with lenders relying on nothing but a sanitised due diligence report from the private equity firm. But in the non-sponsored, lower mid-market, leverage levels are lower and risk is still being appropriately priced.”

The quid pro quo for the sponsor-backed market, according to Leger, is supposed to be that private equity firms will re-equitise the business if it runs into trouble. “But as we have seen over the past year, that is not always the case,” he says. “There have also been instances where the private equity firm has moved assets out prior to bankruptcy. That seems to have come as a surprise to the lenders. But it shouldn’t have if they didn’t stipulate their right to those assets in the loan.”


There are other ways in which covid is likely to affect the competitive dynamics of mid-market private credit. Some private equity firms have been reviewing their private lending relationships. “We have definitely heard of cases where direct lenders have acted opportunistically on waivers and covenants, treating counterparties poorly during the worst of the crisis,” says one mid-market lender who declined to be named. “They have done themselves a disservice and, in some cases, have been removed from sponsor lists.”

Market consolidation may also be on the cards, with a handful of larger firms increasingly taking market share. “There are only five or six players with AUM greater than $6 billion in Europe, whereas there are around 80 with AUM below that,” says Fobel. “There are questions as to whether standalone firms with just a few billion are financially viable as fees can only be charged on invested capital.

“This crisis will have been a valuable test to demonstrate the resilience of an asset class that is still relatively young”
Benoît Durteste

“You have to build your portfolio in order to generate the revenues required to support what is quite a complex business. Many firms started out hoping to raise a second or third fund, at which point they would become cashflow-positive. But time will tell. They may or may not achieve that.”

The marriage between Bridgepoint and EQT is a case in point. “That was a perfect example of Bridgepoint using the acquisition of EQT Credit to accelerate the trajectory of its direct lending business,” says Johnson. “I think we may see more of that type of activity.”

Although investor capital may be consolidating in the hands of a smaller group of larger managers, there is no doubt that LPs’ appetite for the sector is high, buoyed by the defensive characteristics it has displayed during the pandemic and the premium it is able to offer in a lower-for-longer interest rate environment. “This crisis will have been a valuable test to demonstrate the resilience of an asset class that is still relatively young,” says Durteste. “Most LPs intend to further increase allocations to the space.”

An asset class that came into its own – or even into existence – during the last major crisis is being propelled to new levels during the pandemic, as banks retreat further from the business of direct lending. “Covid will only accelerate the growth of this market,” says Johnson. “Instead of private debt being put side-by-side with banks in processes, sponsors will increasingly go straight to direct lenders.”

“The pandemic will be the definitive proof private debt needed of its ability to weather a downturn,” adds Fobel. “It should remove the last question mark hanging over the industry which, combined with the premium returns that private debt can generate over liquid markets, bodes very well for the future of the asset class.”