Track record hinges on underwriting

As the cycle has worn on, memories of the global financial crisis have faded – and so have credit agreement standards. Andrew Hedlund reports

Limited partners put an almost unanimous emphasis on a general partner’s track record when deciding which firms to invest with.

Some 97.6 percent of respondents in our annual PDI Perspectives 2019 investor survey said it forms a major part of the due diligence process when examining potential funds in which to invest. Investors told Private Debt Investor that this is particularly true in private credit – an asset class in which decisions by an individual manager (the firm’s underwriting standards, for example) can play an outsized role in performance compared with other alternatives.

Many investors approach private debt as a potential complement to fixed-income investments, and sometimes a replacement for that allocation. Of course, the caveat that goes unsaid is the assumption that an alternative lender manages its assets prudently.

In the current atmosphere, caution should be the name of the game. Half of non-bank lenders are willing to lend more than 6x EBITDA in the first quarter of the year, according to a lender survey by LPC. That’s almost double the 26 percent that said they would lend above that multiple in the fourth quarter of 2018.

What’s more, non-bank lenders continued to take leadership roles in syndicated deals. Those firms took market share from traditional banks as a bookrunner in syndicated mid-market sponsor-backed deals, according to LPC data. Non-regulated lenders made up almost 40 percent of the market, up from 35 percent in 2017 and from slightly more than 30 percent in 2017.


Documentation plays a large role in lending because it will dictate the extent of recoveries made in a bankruptcy or workout scenario, whereas the equity will almost always be wiped out. Credit managers can assert their deals have financial maintenance covenants, but if the leverage covenant limits leverage at a far-fetched multiple of EBITDA, does the deal effectively have a covenant?

Oaktree Capital co-chairman Howard Marks addressed the matter on the firm’s fourth-quarter earnings call. “Standards for credit issuance have been very loose,” he said. “And so, all things being equal, the defaults will come later than they otherwise would have, but they’ll probably be worse.”

He also noted that companies may be able to continue operating after a breach of covenant. By the time they reach a payment default, the company “would tend to dissipate more of their assets” and “recoveries will be considerably less” he added.

The seeds are being sown now that will be reaped in the next downturn. With direct lending still at the forefront of LPs’ minds, it’s critical to understand the ins and outs of a credit manager’s track record.

This piece was adapted from a contribution by PDI to The Lead Left, a weekly industry newsletter published by Churchill Asset Management.