For at least a year even before the pandemic, investors were alarmed about a possible bubble forming in private credit, an asset class that barely existed until a decade ago when banks stepped back from lending to smaller and riskier businesses. They were right to be concerned: In the years after the financial crisis, investors committed billions to private credit, scores of new asset managers entered the business to meet the demand, and competition for deals became manic.
With the pandemic, the asset class got its first real test. While there were bumps in the road, including a big downdraft in publicly traded business development companies, the sector emerged in good shape.
“All through 2019, there was lots of chatter about private debt. Everyone was piling on, saying, ‘Wait until the first credit event and then we’ll see what happens.’ But the industry held up well,” said Art Penn, founder of PennantPark Investment Advisers. Before founding PennantPark, Penn was, among other things, chief operating officer of Apollo Investment Corp, Apollo’s business development company, and was managing partner of Apollo Value Fund, a distressed fund.
One reason why the asset class has held up: Private credit shops generally finance more stable businesses than the high-yield and syndicated loan markets.
“There’s a misunderstanding about the types of businesses that middle-market private credit investors finance,” Penn said. “Direct lenders generally avoid industries such as airlines, hospitality, oil and gas, movie theaters, cruise lines. If you’re a classic curmudgeonly skeptical credit person, you avoid the heavily cyclical industries.” Companies in these industries are instead largely financed by high-yield and broadly-syndicated loans.
There’s a good reason for direct lenders to avoid these more volatile sectors. Private loans are illiquid, meaning investors can’t sell easily, if at all. As a result, they better like what they’re buying and be willing to hold it until it matures. “Investors in the broadly syndicated or high-yield bond markets often invest in these types of deals under the belief that they can get out if they need to because the loans or bonds are thought to be liquid,” Penn said. “And that’s partially true: There is liquidity, but in down cycles that liquidity can be sparse and at an unattractive price.”
While managers in other sectors of fixed income started loosening covenants — making the terms of an agreement more favorable to the borrower to win a deal — many direct lenders kept covenants strongly in their favor.
As a result, when companies ran into trouble, lenders had a say in the steps that management teams decided to take to solve their immediate problems, including how costs are being managed, what cuts are being made to the business, how cash is being managed, and whether a private equity sponsor might put in more equity.
“Covenants loosened in high-yield bonds and syndicated loans over the past decade,” Penn said. “We have meaningful covenants. With covenants, the lenders get to the table quicker, so we have a much better shot to control our destiny. Otherwise, you’re just waiting around.”
One executive told Institutional Investor that the managers with the fewest impairments were the ones who had the most experience. “It’s really a function of how many deals you’ve done and when,” he said. “The more the better, because you see every possibility.”
Private Debt vs. Bank Loans
During the pandemic, sponsors also got their first chance to compare private debt with the alternative: commercial bank lending. Private debt relies on long-term investments from institutional investors such as pension funds and endowments. Banks, on the other hand, have to optimize their balance sheets and make sure they’re preserving cash at stressed times.
“It was almost a tale of two cities,” said Chris Flynn, president of First Eagle Alternative Credit. “The commercial bank playbook during stress is not borrower friendly. When a company needs liquidity, they traditionally take liquidity away. During this shock to the system, alternative lenders behaved and worked in conjunction with sponsors, particularly when compared to the bank experience. This experience will solidify our position as lender of choice going forward.”
During the worst of Covid, loans got kicked up to a bank’s workout group to figure out what to do with borrowers that couldn’t pay, and revolvers — revolving cash lines of credit — were shut down.
“We’re not declaring victory — we’re debt people, so we’re always a bit skeptical,” Flynn said. “Going forward, more sponsors will come to us, even though banks have slightly cheaper capital.”
Vadim Margulis, co-founder of Alignment Credit, agrees. “We see a steady flow of potential borrowers who come to us looking for alternatives to their long-standing banking relationships,” he said. “Our view is that many commercial banks overreacted and initially over-tightened their lending requirements, expecting a major credit meltdown, which ultimately was avoided in many areas of the market.”
Private debt deals also were cushioned with a huge amount of equity, which takes the first hit in a crisis. Smaller private equity-backed companies — those with less than $50 million in earnings — had a 52 percent equity cushion in 2019, according to Leveraged Commentary & Data, which is part of S&P Global Market Intelligence. That compares to only 32 percent in 2007 and 40 percent in 2008. The growth in equity is a function of the huge amount of money that private equity firms have raised over the last few years. They’ve paid higher prices and put more equity in to support those higher prices. (It also means returns for private equity funds will likely be lower than they have been historically.)
“If a lender has 50 percent beneath them in equity, that means the sponsor has some serious skin in game,” Penn said. “If they bust a covenant they are more likely to support the company with additional equity in challenging times. Additionally, for the lenders to lose a dime, the value of the company would need to decline over 50 percent.”