Before the financial crisis, the private debt market consisted of a smattering of direct lenders. As of the end of 2018, the market had accumulated nearly $800 billion in assets and had enjoyed four consecutive years of $100 billion-plus fundraising, according to consultancy McKinsey.
Basel III, introduced in the wake of the crisis, placed stringent capital requirements on banks, restricting their ability to lend. In 2013, the Final Joint Guidance on Leveraged Lending was published by US regulators, limiting banks from issuing loans of more than 6x a company’s EBITDA. Debt funds, which were exempt, jumped right in.
Direct lending makes up around 40 percent of today’s market, according to estimates by sister publication Private Debt Investor. The majority is made up of funds covering everything from distress to subordinated debt, and special situations to asset-backed lending, spanning the risk-return spectrum. That’s not to mention the post-crisis rebound of collateralised loan obligations, securities backed by a pool of loans.
“It was very difficult to go to a bank 10 years ago and say, ‘I’d like a little bit more leverage, can you price it up just a little bit?’ They would say, ‘We have a credit standard and we do things the way we do them,’” says Romain Cattet, a partner with debt advisor Marlborough Partners.
Buy and build, minority deals, deals in which cashflows are automatically reinvested: all are innovations enabled by the flexible, private debt financing, he adds.
In the past that flexibility came at a premium to bank financing. Fierce competition between debt funds has dramatically narrowed the spread. Competition also triggered the rise of covenant-lite loans, with few restrictions on the borrower and less protection for the lender.
As of August, cov-lite loans accounted for 79 percent of outstanding loans in the US leveraged loan market, according to S&P Global Market Intelligence.
The covid-19 crisis is the first serious test of these loans. Robin Doumar, managing partner of $10 billion lender Park Square Capital, says cov-lite structures should prove helpful to sponsors in preventing “unnecessary balance sheet restructurings”.
A period of poor performance should not necessarily have negative repercussions, he suggests. The European head of a $40 billion private pension fund expressed confidence in his credit investments, saying lenders are “far more sophisticated” risk managers than their reputations bely.
One London-based private equity partner says sponsors shouldn’t bank too much on the flexibility of their lenders. In the second half, once it becomes clearer how businesses have been hurt, debt funds will seek cures to whatever ails them.
“I think it’s going to be a bit of a bloodbath,” the partner says. “Lenders have a duty of care to investors. Why would they not do things to enforce or accelerate the [repayment] of debt?”
Even if things do blow up, private debt is unlikely to be down for long. Private credit firms have raised capital they need to deploy, while private equity dry powder continues to pile up. The crisis is already producing attractive distressed opportunities. If the banks can’t help get these deals done, who else will?