What happens when the financing tap gets turned off?

Debt funds and their portfolio companies have grown used to tapping cheap debt facilities, but underperformance amid the covid-19 crisis may see access to finance restricted.

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We now live in times when many previous assumptions are being challenged. For private debt fund managers, besieged by what has been a rapidly expanding universe of credit line providers, one assumption was perhaps that debt would always be cheap and liquidity for portfolio companies readily available. It’s a view that’s now being revised.

The irony with sudden downturns is that when liquidity is most needed it may well not be there. According to a client note distributed this week by Chicago-based fund finance specialist Fund Finance Partners, debt funds have “billions of dollars of unfunded commitments to portfolio companies, whether in the form of revolvers or delayed draw term loans”. In addition to this, the struggles many portfolio companies are now encountering mean there will undoubtedly be an increased demand for rescue finance.

However, the credit lines that funds would typically use for such purposes often have covenants linked to net asset value or asset coverage. These covenants can restrict access to the facility should the value of underlying loan portfolios fall too far – valuations based on enterprise values that are expected to tumble as earnings decline pretty much across the board.

If these covenants are violated, credit lines can then be made unavailable, potentially starving portfolio companies of much-needed finance. Funds will then be forced to negotiate with credit line providers with a view to negotiating amendments to agreements. If such amendments cannot be agreed, funds will then need to scramble around for alternative sources of liquidity – in an environment where many of their peers will no doubt be doing precisely the same.

One way of freeing up liquidity would be to sell assets at fire sale prices – something no fund wants to be forced into. As an alternative to this fate, some may consider unorthodox solutions to provide temporary liquidity. These include what one source describes as “quasi repo”, whereby assets are sold – probably not to conventional buyers – then repurchased at some future date. Private debt firms themselves could also be part of the solution: we have been told that special situations vehicles may have the flexibility to provide credit funds with refinancing solutions.

Of course, not all funds are equal – and current circumstances may prove to be the ultimate test of who has been deploying capital sensibly. Although valuation declines will be widespread, some will see more dramatic deteriorations than others. Some funds will successfully negotiate refinancings and may even claim a more dominant market position when the asset class, as seems likely, experiences some kind of shake-out in due course.

Write to the author at andy.t@peimedia.com