Far from normal

A sense of stability is beginning to return to US credit markets, but the stresses caused by covid-19 are all too visible.

“While there has been a gradual, perceptive uptick in overall confidence since June – primarily because of the bounceback in the capital markets – lenders’ pipelines remain far from normal as we head into the end of Q3,” says Twin Brook Capital Partners’ Garrett Ryan.

The situation is unprecedented, the consequences unpredictable. Everyone knew the cycle would turn at some point, but could anyone have foreseen whole swathes of the economy being shut down? “What’s unique is that you had instantaneous supply and demand destruction,” says Ian Fowler, co-head of Global Private Finance Group at Barings. “All industries were affected.”

Front-line consumer businesses fared the worst but there were also “contrarian effects”, says Randy Schwimmer, senior managing director at Churchill Asset Management. “Low-cost fitness clubs have historically done well in recessions; but with this iteration, members were shut out of gyms. On the other hand, some catalogue businesses are growing because people are stuck at home reading their mail.”

For the private debt industry, there’ll be winner and losers: “It will be a tough road if you are a one-dimensional platform without scale and diversification in your capital base and have portfolio issues,” says Fowler.

MGG Investment Group’s Daniel Leger and Gregory Racz argue that the winners will be those who have shown discipline as markets flourished.

Problem loans will come home to roost. “The more loans that require a workout during a crisis, the less time and capital a lender will have to invest in new opportunities,” say Leger and Racz. They believe the pandemic provides a timely reminder of the importance of old-fashioned virtues such “lender-friendly structures with tight covenants and modest leverage”.

So, safety comes first, with the first order of business “to play defence”, argues Christopher Hardison, managing director for private debt America at Partners Group. This has been a very different crisis than those of the past, he says: “Certain sectors that are typically less insulated did very well, and some sectors that the market thinks were insulated were hit hard. It was impossible to predict how portfolios would be impacted ahead of the pandemic.

“But that doesn’t mean you couldn’t prepare. This is where having a strong restructuring team in place is important. It allows you to work through any issues in the portfolio.”

Opportunities are opening up

Understandably, perhaps, fundraising took a bit of a battering in the first half, with North America-focused funds bringing in $18.6 billion, down from $37.4 billion in H1 2019.

But it wasn’t all doom and gloom. Far from it. There was a rise in the number of dedicated distressed and special situations funds coming to market in the first half, including US-domiciled vehicles such as Oaktree Opportunities Fund XI, Centerbridge Special Credit Partners IV and Fortress Credit Opportunities Fund V.

Institutional investors have been quick to recognise the opportunity. The Florida State Board of Administration – which manages the $165 billion Florida Retirement System Pension Plan – told its trustees on 30 June that it had earmarked 20 percent of its dry powder for distressed strategies.

“We think this is probably the best distressed opportunity perhaps ever,” Trent Webster, senior investment officer for strategic investments, told members of the investment advisory board. “By some estimates, the distressed opportunity is twice that of the global financial crisis, which is utterly astonishing, considering that was the closest we came to another Great Depression in our lifetime.”

There are some caveats. Aaron Peck, managing director and co-head, opportunistic credit at Monroe Capital, says there is now too much money competing for the same opportunities in the traditional distressed market.

“There are limited opportunities in the distressed market today,” he says. “You have to have a very specific view of a quick economic recovery to make most trades in distressed right now.”

But vintages following market downturns have historically provided attractive opportunities and investor appetite is growing for private debt, says Timothy Lyne, chief operating officer of Antares Capital.

“We also think this stressed environment is an opportunity for differentiation in performance among lenders and potentially for continued consolidation, as weaker, sub-scale lenders either go out of business or get swallowed up,” he says. Lyne also believes it provides “attractive fertile ground for the considerable stockpile of available PE investment funds”.

Put the portfolio first

For all the talk of growth, this crisis has clearly spooked even the most hardened observers. And that has put portfolio management and risk analysis front and centre stage. “As a private lender, the best way to make money is not to lose it in the first instance,” says Brent Humphries, president, AB Private Credit Investors. “Excelling in the area of portfolio management will provide direct lenders an opportunity to deliver best-in-class performance.”

The result is a renewed emphasis on portfolio construction and analysis. Northleaf Capital Partners has brought in a new “integrated” investment process that combines bottom-up asset selection by deal teams with a top-down perspective managed by a dedicated portfolio analytics team.

“One of the fundamental challenges that private credit fund managers face is objectively comparing risk, both as between potential investments and within a portfolio as it evolves over time,” says Jon McKeown, managing director, portfolio strategy and analytics, Northleaf Capital Partners.

This has meant, in the current environment, thinking through the degree and nature of exposure to coronavirus risk, for example, and establishing a regular forum for the portfolio team to share insights with the broader investment team.

For Churchill Asset Management, the lessons learned from the 2008-09 financial crisis are proving invaluable. “Our long-term strategy of focusing on defensive, non-cyclical businesses carried us through the GFC, and is paying off in this crisis,” says Schwimmer.

However, he also remains confident that private debt could emerge from the pandemic with strong returns: “Spreads have widened, leverage has contracted, and structures have tightened. This could end up being the best loan vintage in a decade.”