A tale of two worlds
We couldn’t have chosen a more uncertain time to consider the future of private debt. With the world seemingly poised for a second wave of the coronavirus, it’s difficult to accurately predict how the asset class will develop over the coming years.
That said, some future pointers are beginning to emerge from the pandemic. The first is a dividing line between the covid and the non-covid universes.
It is, as Paul Hastings partner William Brady puts it, “a tale of two worlds”: “There are companies that went into covid with good balance sheets and are not in the severely impacted sectors, where lenders are supporting refinancings, sale events or strategic acquisitions.
“And then there are the companies that were already wobbly going into this, or that are in retail or hospitality, where the demand is for liquidity solutions and the issue is defence rather than offence.”
Andrew Konopelski, head of credit strategies at EQT Partners, agrees. “We are now dividing the world into potential covid and non-covid impacts. We agree that economies will heal, but it is likely to take quite a long time. We have not seen the bottom yet. If you look at the global financial crisis, it took over five years for leveraged loans to get back close to pre-GFC levels.”
There’s already been a well-established switch towards special situations and distressed opportunities in the first half. “We are seeing a wide array of special situations work,” says Brady.
And LPs are assessing their risk profiles, says Konopelski: “We expect many LPs will shift a bit back towards riskier strategies. If you think about the risk/reward curve, you’re looking at 10-13 percent plus unlevered net returns from credit opportunities and distressed strategies. “The market environment is going to produce some very interesting opportunities over the coming years.”
All eyes on refinancings
There’s also the return of some old friends, as refinancings take centre stage. With so much uncertainty, CLO funds are building up and securitisation looks set to play a big role in refinancing, says Rolf Caspers, global head of capital markets at Sanne.
“CLO funds have been ramping up slowly for the last few years. Some are in a bit of a tight situation because borrowers are having difficulty repaying or are taking a payment pause. But the product is powerful and fits the time,” says Caspers.
No one can say that a downturn wasn’t predicted in credit markets. But the abrupt arrival of the pandemic looks set to unravel some long-held assumptions. Take the fraught area of covenants. A downturn had been expected to stem the relentless advance of looser lending covenants into private debt markets, where 87 percent of global leveraged loans were cov-lite in 2019, according to S&P Global Market Intelligence.
“We expect many LPs will shift a bit back towards riskier strategies”
“We thought this could be the moment when the market takes stock and undergoes a correction on documentation and terms, but it wasn’t,” says Jeremy Duffy, partner at White & Case. “We saw a series of waivers of covenant testing, and the imposition of minimum liquidity covenants and attaching terms including increased reporting obligations. Importantly, we did not see covenant-lite fundamentally altered.”
It’s a volatile environment and that has heightened the need for transparent, accurate data. As Jocelyn Lewis, executive director for private debt strategy at IHS Markit, says: “If you tie that volatility back to the importance of being able to manage your information and leverage technology to illustrate how all these changes will impact investment performance, you can see how useful that data can be for managing communications.”
The rise and rise of ESG
That need for transparency and accurate data extends to another big trend in private debt: the increasing use of environmental, social and governance criteria as a means for investors to choose fund managers.
“It is sometimes argued that debt investors can’t exert any influence because they aren’t voting shareholders: we disagree,” says Stephen O’Neill, head of private markets and investment proposition at the UK’s multi-employer pension scheme, National Employment Savings Trust (Nest).
“The virus hasn’t pushed ESG down the agenda – if anything it has gone up now”
“An off-market lender has a lot of power – often private lending involves follow-on loans, and provisions for the lender to temporarily relax the terms of the loan. These can be withheld if the borrower isn’t doing what is expected of it, whether regards to financial prudence or ESG behaviours.”
Patrick Marshall, head of private debt at Federated Hermes, thinks ESG risk should be assessed as any other. “Unless you can understand these risks, you won’t be able to understand how a company is run or know if you are being adequately remunerated for the risk you are taking on,” he says.“Nor will you be able to try and change any questionable behaviour by the company.”
Federated Hermes uses ESG as a risk management lens across its entire private credit portfolio. “We actually turn down around 20 percent of all loans we see due to concerns around ESG,” says Marshall.
And covid-19 has made ESG even more of a focus: “The virus hasn’t pushed ESG down the agenda – if anything it has gone up now that people have started to realise just how clean the air and water can be,” says Sanne’s Rolf Caspers.