In the words of one panellist at this week’s PDI New York Forum: “It’s the most aggressive market we’ve seen in direct lending in 22 years. People are going deeper, cheaper and with no covenants.”
Perhaps the most referenced manifestation of questionable market practice is covenant-lite, which now features in the majority of deals at the larger end of the loan market. But numerous delegates in the Big Apple felt this was old news. Covenant-lite is the new normal – other creeping structural changes, such as EBITDA add-backs, the ability to add debt post-deal and the erosion of the collateral pool, make fewer headlines but are potentially more damaging.
This point was certainly hammered home by the latest memo from Oaktree’s Howard Marks in which he lists some of the most “imprudent” deals seen by the firm’s investment professionals. One showed an adjusted EBITDA figure that was 190 percent of reported EBITDA and where total leverage was 7x based on the adjusted figure, but 13.5x percent based on the reported figure.
One representative of a ratings agency predicted that egregious developments such as these are sowing the seeds for the next downturn, in which recovery rates are predicted to be lower than they have been historically.
So far, so bad. But the real challenge for the private debt market is that nothing bad has happened yet. Indeed, there is an increasingly striking contrast between the strong fundamentals being seen currently – robust company earnings, solid debt service coverage ratios, low default rates, etc – and the future that people are being invited to contemplate.
Some may be tempted to savour the here and now and refuse to entertain negative thoughts. After all, why worry about what you can’t predict? Speakers and panellists were quick to confess their limitations when it came to pin-pointing when the cycle will turn. One gave a precise date – but did so in jest (we think). Others either said frankly that they had no idea or that, over the next year or two (beyond which, it’s guesswork), conditions are likely to remain broadly benign.
Investors, however, are keen to know that the managers they back are prepared for the worst. Anecdotally, they are doubling down on due diligence to identify those groups best able to keep their heads above water through a downturn. GPs are also being advised to hire all the workout experts they will need now, while they are still affordable. Wait until a downturn actually starts and suddenly that kind of talent could become prohibitively expensive.
Preparing for the bad times should start now, if it hasn’t already – even as the good times continue to roll.
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