The pandemic highlights the value of cash preservation

The ease with which capital could leak out of businesses was symbolic of borrower power in deal negotiations. A more challenging environment has put this in a harsher spotlight.

With many firms not having experienced a crisis before, this was always destined to be an illuminating period for the private debt industry. Although there’s a well-known saying about being careful what you wish for, many investors in the asset class had been whispering to Private Debt Investor that the onset of testing times would be no bad thing. It would enable them to see more clearly what happens in the private debt arena when the proverbial hits the fan.

In the aftermath of the initial covid outbreak, attention naturally fell on how sponsors and lenders would come together to tackle issues within portfolio companies. Would they resolve these issues amicably or would they go at each other tooth and nail? Although the latter might have made for a more entertaining spectacle, we have received so many reports of collegial behaviour that we have to assume there’s at least some substance to them. When the need was most urgent, sponsors and lenders realised they had significant overlapping interests. Many investors we’ve spoken to have been impressed by this.

This is not to say there has been no tension in the market at all. With deal documentation having been weighted so firmly in borrowers’ and sponsors’ favour in recent years, it would be surprising if lenders passed up an opportunity to draw attention to past sins. Perhaps the biggest transgression pre-pandemic was sponsors’ ability to leak cash out of businesses. In a Friday Letter in January last year, a couple of months before the coronavirus started to spread around the world, we highlighted how so-called restricted payments were failing to live up to their name – with these payments sometimes being permitted even when a company was heading into a distressed situation.

When the pandemic struck, and many companies saw their revenues dry up overnight, it was clear that this was, above all, a liquidity crisis. The key concern was to preserve as much cash as possible within companies to see them through their immediate difficulties. Some of this support came from government schemes, but much of it came from private equity sponsors.

Before covid, Private Debt Investor would have taken a guess that most of the recriminations over deal documentation in the event of a challenging market environment would have been about EBITDA addbacks and the way some of these allowed companies to take on excessive amounts of leverage. Instead, the focus appears to have been on the value of cash preservation. For the long-term health of the market, that’s probably no bad thing.

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