Private credit could benefit from an upheaval in the public markets and a further retreat from lending by the banks in the event of a slowdown.

Chris Skinner, head of UK debt and capital advisory at Deloitte in London, says the freefall in the public markets in early March highlights just how far private credit has come.

“The most profound impact is on businesses in the syndicated markets at the moment,” he says. “The interesting dynamic is that if this had happened two years ago, there simply wouldn’t have been any other option – any deal relying on the capital markets would have had to have been pulled. Now, borrowers really do have another choice. This should be a huge boon for direct lenders, both because they are a genuinely credible source of finance for deals at the moment and because in the longer term it might change behaviours as borrowers realise they might want back-up options rather than just relying on the capital markets.”

Another potential upside for private credit is the fact both documentation and pricing should move in favour of lenders. Neale Broadhead, head of European private debt at CVC Credit Partners, says: “In the last recession, much stronger documentation came through, pricing improved markedly and structuring improved as well. Equity cheques went up and leverage came down. Often, really good deals get done during downturns, because all of those things are good for us.

“We are all sitting on dry powder and want to deploy in the strategies we talk to our investors about. Good companies will always get financing and we will remain on the lookout for deals.”

Deployment could well become an issue if M&A activity falls dramatically, however. With direct lenders so reliant on the pace of private equity dealflow, the challenge could be around keeping investors happy in the absence of good credits to lend to.

Downside risk

Many direct lenders, of course, posit that the whole private debt business is focused on downside risk.

Chris Fowler, managing director at CVC Credit Partners, says: “Firstly, on the portfolio side, we are staying as close as we can to existing investments. We are managing a portfolio of tens rather than thousands of companies, and for most of those we are the sole lender, giving us great access to management and the sponsor. We are not typically on the board, but we are able to influence behaviour, so we are encouraging sponsors and borrowers to think about mitigating actions and contingency planning.

“Nothing is recession-proof, but there are various degrees of resilience”

Susan Kasser
Neuberger Berman Private Equity

“In direct lending, we start off in a good position: we are very close to management and the loan-to-value is typically sub-50 percent, so someone else is going to take a lot of pain before it starts impacting us.”

The fact private equity sponsors are behind most direct lending transactions is a further downside protection. Susan Kasser, co-head of the private credit business for Neuberger Berman Private Equity, says: “The good thing about a private equity firm owning a company you are invested in is that those people always have capital. They have long-term locked-up money and it is available; they can call it in any environment.

“Secondly, they always have the ability to put money in. They don’t have to argue about valuation because they have control of all the equity and access to capital at short notice. Most problems can be fixed with capital, so the fact that you are lending to a company that has access to capital is a huge leg-up.”

A big concern is always that companies may run out of liquidity, in the face of a demand shortfall or an absence of bank lending. Here, Kasser argues the direct lender can always step up because it, too, has access to long-term locked-up capital that it can always make available to good credits.

Key to resilience

But that does not mean private debt teams are immune to downturn risks. Kasser says: “There are fundamentals to the asset class that are very protective, very downside-oriented, but then there’s the reality, which is that when you lend money to companies and they participate in the real economy, they are not recession-proof. We take a position that nothing is recession-proof, but there are various degrees of resilience.”

Mike Dennis, partner and co-head of European credit at Ares Management, adds: “We generally don’t like anything cyclical, so you’re not going to find a lot of overtly consumer-oriented deals in our portfolios. What we tend to invest in are defensive sectors like healthcare, education, business services, software and technology, where there are lots of contracted revenues. Those companies are not wholly correlated to the macro environment.

“Our strategy is based on capital preservation and putting together diverse pools of capital for our investors. One of the mitigations to risk is diversification; in our prior fund we had 68 different investments and so no one asset was likely to materially impact the overall performance of the fund.”

At an asset level, he says the risks associated with slowing economic growth can be mitigated through a combination of governance, terms and structuring. “We back that up with really robust portfolio management and the experience necessary to restructure companies if we need to,” says Dennis.

Despite the bullish message coming from established mid-market direct lenders, it is hard not to envisage a market post-slowdown that has fewer active managers in the space. In a crowded and highly competitive environment, some direct lenders are bound to fail because their portfolios are not sufficiently diversified or because of a few unexpected defaults or bankruptcies.

In the meantime, the stronger players will need to continue sourcing new transactions. Blair Jacobson, partner and co-head of European credit at Ares Management, says: “We believe we will still be able to find interesting deals to review as transaction activity slows. A big part of what we do is refinancing, and we have six offices in Europe with 60 people looking at opportunities. The private equity firms have billions of dollars in committed capital to invest in the European mid-market, so we believe they will be seeking to deploy over time.”

Fowler adds: “In the mid-market where we are operating, transaction flow isn’t dictated by public market valuations. A lot of what we do involves financing growth plays, and those mid-market sponsors keep busy. Even in 2009, teams were still doing mid-market deals when the large-cap teams were sitting twiddling their thumbs.”

And if transactions are hard to come by for a while? Kasser says: “Our investors are happy with us not because of our deployment but because of our low losses and good returns. Lending money is great, but you don’t get credit if you don’t get it back. If we deploy very little capital in a quarter because the markets are not good, our investors are fine with that, and I’m fine with that.”

Most agree that at least the next two quarters of 2020 are looking challenging on a macro level globally. But from direct lenders operating in the mid-market, the message is that there is no cause for alarm.