It is well documented that the private debt market, especially in Europe, developed as a result of the post Global Financial Crisis market conditions. Primarily, a low interest rate environment and increased regulation placed upon the banks and their subsequent retrenchment from the SME lending arena. Since then there have been some local economic crises; Greece, Venezuela and Turkey to name a few but how the fledgling asset class performs during the global COVID 19 crisis will be its first real test. As a result I thought it would be worthwhile looking at how I expect private debt to perform and how the asset class will look when we come out the other side.
To start with the political and economic conditions that enabled the growth of the market remain in place. We are still in a low interest environment and given the stimulus required to combat COVID 19 it is hard to see interest rates rising in the short to medium term. However, even in the unlikely event interest rates were to rise I believe the investment rationale for private debt is unaffected given that most investors are looking for the risk adjusted return above the risk free rate and the floating rate of interest provided would move with this to continue to make the investment attractive.
We are also unlikely to see regulation of the banks relaxed anytime soon, despite the regulation cutting ethos of the current US administration. Although new legislation, such as Basel III has been delayed in order to give the banks operational capacity to deal the crisis. One potential area to note here however is the increased dominance of the biggest market participants. In recent years there has been a trend for the larger alternative multi asset managers to pick up even more of market share. The underlying rationale being that we were at the top of a circle and when a market correction comes the big players with strong workout capabilities and deep pockets would be the best partners to be in bed with. In my opinion the current crisis is likely to accentuate this. As bigger funds do bigger deals there is a danger they could show up on more regulators’ radar and if banking style obligations are placed on the alternatives industry this could be a real concern.
In the UK, the government has introduced the Coronavirus Business Interruption Loan Scheme (CBILS) to support SMEs across
the UK that are losing revenue or seeing their cash flow disrupted as a result of COVID 19. The scheme allows accredited
lenders to provide government backed loans to encourage lending, for businesses that were financially sound prior to the
crisis. At the time of writing there are 40 accredited lenders consisting primarily of high street and challenger banks and smaller specialist local lenders. There are also some fin-tech or peer to peer lenders such as Funding Circle, Thincats and Askif that are included within this group. It’s great to see the technology developed by these, and other, alternative lenders being utilised by the government for the economic health of the country. However, there have also been criticism that the process is currently too slow and reports that only one in five businesses have been accepted to date. One significant change to the landscape over the last decade has been the considerable migration of talent from the banks to the private debt managers. Given the credit analysis skills and private debt’s speed of execution perhaps more alternative lenders being accepted as accredited lenders would be one way to improve the scheme. If this was to happen then private debt would potentially take a significant step into the mainstream.
On the flip side of this however, is also concern from some private debt managers that CBILs will increase leverage in the SMEs that they have already provided finance too and will negatively impact their risk adjusted return. One solution is for the government to provide an equity relief instead of the current debt option or as previously mentioned include private debt managers as accredited lenders to provide a level playing field.
In terms of how the current private debt market will perform, I believe the flexibility of alternative lending will be a positive but also potentially my main concern. The creep of cov-lite deals into the mid-market, which is likely to be most affected by the current crisis, has been well documented. How managers perform during this period will make a significant difference for the perception of the asset class going forward. Obviously loosing of lending terms around financial covenants and information undertakings might make lenders jobs that much more difficult. Early detection of an underlying issue is often key to ensure the best possible outcome is secured. However, to remain positive this also provides an opportunity for managers to demonstrate their credentials. When listening to LPs talk about their selection process, one criteria that is regularly brought up is the potential managers track record when dealing with defaults and their ability to successfully workout difficult situations. Given the relatively short life of private debt to date, this would not always be easy to demonstrate. My expectation is that the asset class as a whole will perform well and provide additional comfort to future investors looking to allocate to private debt for the first time or increase their allocation.
The flexibility private debt managers can provide when negotiating deals can also work in their favour when working with borrowers during an issue. The current crisis is unusual in so much as many good businesses have seen their revenue or cash flow stop almost overnight and reduced to zero in many crisis. This is obviously much quicker and more aggressive than you would see in a downturn, even one as severe as the global financial crisis. There is obviously a lot of uncertainty about how the lockdown will be eased, what the new normal will look like and how long it will take us to get there. But in the spirit of being positive there should also be a lot of businesses that will return to profit once these adjustments have played out. As a result, the private debt fund, being closed ended, bespoke and providing term loans is well placed to be able to take a whole loan view and work with borrowers to provide payment holidays, additional liquidity and covenant waivers in order to avoid default when the long term prospects remain positive.
A second consideration in relation to the impact of cov-lite deals is that these are primarily found in loans provided to PE sponsored borrowers. It is likely to be the PE sponsor that negotiates the reduction in terms given their increased familiarity with the market and ability to negotiate. Therefore the lenders on these deals have the added protection that is provided by having a PE sponsor taking the first hit risk. The theory is that the PE sponsor would act to protect its investment and therefore also reduce the credit risk to the debt fund given its superior position in the credit stack.
Further opportunity is also likely to arise due to the wide spectrum of strategies available within the private debt asset class. Lots of people, especially outside of private debt professionals, only associate the asset class with direct lending but as the industry evolved there are many variations available for investors’ preferences and to combat the cyclical nature of economics. Two important strategies at the moment are NPL and special situations. Given the anticipated increase in the default rate it can be expected that the asset availability for non-performing loan funds will grow too. Banks will need to remove NPLs from their balance sheets and the track record of NPLs, especially in relation to portfolios managed from Ireland, Spain, Portugal, Greece and Italy over the last decade make NPL managers well placed to benefit from this but also to help the general economic recovery as the managers and servicers can work with the struggling borrowers to turn around their loans to a greater extent than the banks can do so. I believe it is a common misconception that NPL funds aim to recover what they can through the courts when in reality avoiding the cost and time involved during insolvency hearings is a priority.
Similarly special situations funds are likely to have increased opportunity to make attractive investments. One of the short term impacts is likely to be a drop in fund raising while working through the crisis however I believe special sits is likely to buck this trend as managers recognise the vast opportunities available and look to raise and deploy quicker than they might have anticipated at the start of the year. For the wider debt market the recent high levels of dry powder have also potentially poised a problem, when fundraising and with pressure to deploy capital. While fundraising is slowed efforts can be focused on deployment and once valuations settle you should expect some attractive deals to be agreed across the asset class. On that basis the 2020 and 2021 vintage of debt funds could be some of the most attractive on record, which again only helps managers to fundraise in the future.
A slight deviation from my earlier point in relation to the largest managers continuing to grow and dominate is the potential for smaller, start up, spin off managers to develop out of this crisis. As mentioned in the above paragraphs there are inevitably going to be good opportunities for managers with the requisite skillset and this could prove too tempting for any aspiring start up managers. Although fundraising might be difficult for those that do dare and manage to invest the strong track record that could be attained as a result could pay off that risk handsomely.
In conclusion there are clearly challenges that the private debt market will need to overcome however I believe that the fundamentals of our business are strong and the quality of the people involved will help the asset class to perform well and continue to grow, mature and come out the other side of this crisis stronger. In 2017 Preqin predicted that the private debt market would double in size from $0.7tn to $1.4tn in five years, the current crisis might significantly impact the short term but I for one would still not be surprised to see private debt continue its remarkable growth story.
If you would like to find out exactly how LGL can help you, please contact the author of this article, LGL’s Head of Debt, Stephen McKenna