Changes Expected in the Private Debt Market
Introduction
Private debt is a type of debt that is usually issued to middle-market companies in private. As a result of bank industry consolidation, many non-banks started lending to medium-sized businesses. However, the private debt market grew rapidly, and even some companies with more than $1 billion in revenue now seek financing services from non-banks.
As the pandemic increased default risk of businesses around the world, the yields on debt investments increased, attracting more investors into the private credit market. Recently, many major funds have successfully started and raised multi-million, multi-billion funds to capture the market dislocation opportunities in a distressed economic environment.
Recent Credit Funds Raised
Owl Rock: $1.5 billion - Opportunistic Debt Fund
CVC: $657 million - US Focused Direct Lending Fund: Senior Secured Loans
HPS: $1.5 billion - Specialty Finance Fund
Arena: $300 million - Asset-Backed Debt & Real Estate
Ares: $3.5 billion - Special Situations Fund
JP Morgan Asset Management: $3 billion - Real Estate Credit Opportunity Fund
ADM Capital: $630 million - Private Credit
Potential Private Debt Industry Consolidation
While major players in the private debt market are successfully attracting new LPs, many relatively small private debt funds are expected to struggle. Adams Street Partners, a $41 billion
private market investor, has realized that the market competition is weakening. Bill Sacher, the head of private credit, mentioned that the private debt investors are gaining more negotiation powers, and he’s also currently buying leveraged loans at low prices. From his comments, we can take away two important points. The first point is that lenders are gaining power as a result of lessened competition within this market. As a result of the coronavirus, many portfolio companies will default on their loans, distressing many private debt funds. As a result, bigger investors, like Adams Street, will buy loans at cheap prices and become even bigger.
We’ve seen a similar phenomenon in 2008 when major investment banks acquired other big banks as a result of the subprime mortgage crisis. Lehman Brothers went bankrupt and Barclays bought their business at a huge discount, while Merrill Lynch was bought out by Bank of America. Although we’re currently only seeing a few big funds buying individual assets at cheap prices, more consolidation in this industry is expected to come as more fund-scale acquisitions are expected.
Having said that, Ares has already made two acquisitions this year before the coronavirus pandemic: acquiring a majority interest in SSG Capital Holdings and acquiring a managing interest in a restructured Crestline Denali Capital, resulting in an addition of seven CLO funds. Although the company did not make acquisitions because of the distressed opportunity provided by the pandemic, these corporate actions hint that major players in this field will actively look to acquire distressed debt portfolios as well.
Current Activities in the Private Debt Market
Another change recognized within this industry is the share of different deal types. While the majority of private debt deals were investments in leverage loans as a part of private equity deals, more non-sponsor direct lending deals are expected. When an economic crisis happens, two things happen that result in a lower private equity deal volume: lower multiples disincentivize business owners and private equity funds have a hard time managing their portfolio companies; thus, less leveraged buyout deals are expected. Moreover, private credit lenders are also busy injecting needed liquidity to their portfolio companies to survive, moving their focus away from new private equity deals.
As private credit funds operate with a “buy and hold” strategy, most, if not all, private credit funds are playing defense to keep their portfolio companies alive rather than playing aggressive offense. GSO Capital’s Managing Director Brad Marshall said, “Being defensive right now, focusing on your portfolio companies, minimizing losses, those are your keys to success over the long term… we are spending a lot of time with sponsors or companies and trying to figure out what the best path forward is, like any partner would do.” When asked about the current approach to the market, CEO of Antares, David Brackett said their focus is on their portfolio and helping out the borrowers in the long term. Michele Kovatchis, head of the credit advisory group, added by saying that they are making amendments to the credit terms, including the rates, covenants, and more. Since private credit lenders require a positive long-term relationship with their borrowers, they need to do whatever it takes to help their portfolio companies survive.
Who will survive
However, what will really separate some direct lenders from others is their ability to play offense right now. If a lender deployed capital too aggressively prior to the pandemic, there is a high possibility that this manager will fall out of the expanding private credit market. The amount of excess capital is very important because playing defense and offense both need cash. However, if a fund has more than enough cash to play defense, this investor can play more offensively by investing in new targets with higher returns. While playing defense will help a private credit fund survive this crisis, a fund’s ability to play defense and offense at the same time will allow that fund to come out much stronger than other players.
Rates
As a result of the high demand for liquidity, the yields on private credit investments are getting juicier. An article from Bloomberg mentions that “A unitranche loan for a company with more than $40 million of earnings before interest, tax, depreciation, and amortization is likely to command 650 to 750 basis points over Libor currently, according to Lincoln. A senior loan will probably price around 500 to 600 basis points over Libor, while a second-lien would be around 900 to 1,050 basis points over Libor, according to Lincoln data.” This is an incremental increase of 100 to 250 basis points compared to last year as credit risks are higher.
Why More LPs will become attracted
The private credit market has proliferated, and more institutional investors have become interested in locking their money in these funds. While banks used to be the main source of capital for businesses, the industry became so consolidated that more regulations led to less risky investments and underwritings. Moreover, the number of public companies declined rapidly from the late 1990s as the number of public companies declined by 50% from 1996. Along with this trend, many investors lost appetite in the public debt market and searched for private market investments.
Now, banks are more hesitant to make loans to their customers. US banks started pulling back from lending to European companies recently as Europe has been struggling from its earlier economic crises. These risk-averse actions from the US banks show that financial institutions are becoming cautious of lending to riskier businesses, and this gap of capital demand can be filled with non-bank lenders. Moreover, as investors recognize high volatility in the public market, more institutional investors can be attracted by the private market’s low volatility.
Another factor that attracts the investors to the private market is the differences in multiple between the two markets. The public market gets affected by so many factors that it doesn’t represent the right value of the company many times. However, as the public market experienced high growth until the coronavirus, the multiples have been very high compared to the private markets. According to S&P’s data, public companies’ average EV/EBITDA multiple was higher than private companies’ by 1.0x - 2.0x from 2016 to 2019. If investors also realize this overvaluation of the public companies, more investments into private debt funds can be expected.
As the private debt market is yet considered one of the niche markets, many investors are not fully aware of the benefits of investing into private debt funds. However, with the new economic crisis, investors are now seeking other asset classes where they can lower volatility risk and receive more stable investment income. Since the private market is much less volatile than the public market, we can expect to see the private debt market attracting more investors, subsequently leading to a private debt market boom.
References:
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