Private debt can flourish in a crisis - because it can adapt
As 2020 began, the private debt market had experienced a decade of growth, and mounting competitive pressures had resulted in “borrower friendly” terms. In a few short weeks, the Covid-19 pandemic has brought M&A activities grinding to a halt. New private debt investment activities have declined dramatically.
The lock-down measures implemented around the world to contain the pandemic have been unprecedented. The effects for companies in the most exposed sectors - such as retail, travel, and leisure - have been immediate. However, the many uncertainties around the timing and shape of a recovery mean it is still too early to establish an accurate picture of the impact of Covid-19 across private debt.
Nevertheless, with private debt increasingly viewed as an important source of liquidity and long-term finance, we see clear signs of the pendulum now swinging in favour of lenders. We believe that for private debt managers who can dynamically respond to the challenges borrowers face, there are attractive investment opportunities emerging out of the Covid-19 crisis.
Flexibility and patience
The current crisis is arguably private debt’s first real trial. It was from the ashes of the global financial crisis (GFC) that the industry truly emerged, evolving into one of the largest and fastest growing private market asset classes. As a result, we expect Covid-19 will be viewed by history as a demarcation point for private debt; one that tests the borrower-friendly terms of the recent past. Portfolio construction will also come into sharp focus, as private debt funds with relatively large exposures to consumer discretionary spending and cyclical sectors are likely to be impacted more heavily than well diversified funds comprising largely defensive sectors.
So far, no industry-wide rises in defaults or loss rates to have appeared. Private debt, typical of other illiquid asset classes, does not have secondary markets where pricing data can be easily procured. Combined with the usual valuation lags, it may be some time before signs of marked valuation impact become notable.
However, much work is carried out by private debt managers before impairments are reflected in investor reports. Key differentiators of private debt from other sources of debt capital include flexibility and capacity for long-term views. In times of stress, focused negotiations can result in short-term arrangements - including interest payment deferrals or covenant waivers - that can provide the needed time for borrowers to weather through the short term challenges and prompt additional fee revenues for lenders. For the end investors or limited partners, it is important to be able to discern where the portfolio stress might originate and how distributions to investors may be impacted by these negotiated arrangements.
On the other hand, existing portfolio companies in times of limited liquidity can also prove to be sources of attractive investment opportunity. Selectively providing additional funding for borrowers facing short-term cash flow challenges can place existing direct lenders in a uniquely strong and proprietary position. As a rule, these “top up” or “bridge financing” loans are provided to borrowers with whom managers are already very familiar. The returns from these loans can provide relatively attractive yields, with higher underwriting fees and other one-off charges. Even so, utmost underwriting discipline should be exercised. The key focus should also be on working with portfolio companies facing short-term liquidity challenges but expected to emerge with long-term resilience.
Where are the new deals emerging?
The Covid-19 crisis has prompted unprecedented government financial assistance. Banks today are also in better financial and regulatory positions compared to the GFC. Even with these developments, we believe the crisis will extend the reaches of private debt, due to its flexibility and ability to work closely with the equity owners.
At this stage, Coronavirus has largely halted M&A activities; the main source of direct lending transactions. Deal infrastructure and logistics have been challenged by stringent social distancing policies and virus containment measures. In other words, it’s hard to do business when you can’t sit in the same room. Potential buyers, including private equity sponsors, have also shifted their primary focus to managing existing holdings.
Nonetheless, the few completed deals and growing pipelines of potential investments show promising signs of risk-reward balance skewing towards the private debt lenders. Banks are exhibiting low risk appetite given lack of visibilities, retreating from underwriting new investments. As a result, private debt managers are now also being sought out by larger and higher credit quality borrowers who, before the current crisis, had alternative financing options in banks and broadly syndicated markets (BSM). These loans are currently being considered under more conservative terms, far more favourable to lenders than transacted at the beginning of 2020 - wider spreads, longer call protection periods, higher underwriting fees, and with covenants.
As the timing and shape of recovery remains uncertain, pursuit of new investments needs to be highly judicious, focusing on defensive sectors including healthcare, pharmaceutical, and business/IT services. Companies most likely to prove resilient under the post Covid-19 macroeconomic paradigm will include asset-light businesses, operations with contractual income flows and those with high cash flow conversion.
Given the market dynamics, we also expect a relatively high concentration of more senior ranked loan opportunities with lower leverage. For those private debt lenders with flexible mandates, discounted secondary opportunities related to BSM could prove attractive. Private debt managers with an experienced underwriting team and scale to deploy resources and funding flexibly will be best placed to take advantage of these new market developments.
Putting it all together - partnering with the right managers
Our outlook for 2020 emphasised the importance of being selective with debt fund manager partnerships. Success in managing portfolio company liquidity challenges and deriving additional returns from the difficult market environment requires both expertise and flexibility. Working with private debt managers who can risk-manage as well as capitalise on the uncertainties is crucial for investors to navigate the uncharted waters of Covid-19 crisis.