An in-depth version of this Insight was first published in Butterworth's Journal of International Banking and Financial Law (June 2020) – (2020) 6 JIBFL 384 (paywall may apply).
Two preliminary observations
All funds are not created equal
The 'private debt' umbrella houses a diverse array of strategies, each with its own focuses, risks and objectives. These include senior secured, unitranche, junior, distressed, opportunistic, structured equity and specialty lending. Consequently, comparison against 'private debt' as a single asset class is fundamentally misleading. Query whether the market's earlier experience of debt funds occupying the junior / distressed debt space has led market participants to question whether debt funds might be more aggressive than their syndicated lender or clearing bank counterparts in a downturn.
Risk and return
Features commonly found in debt fund (especially unitranche) deals entail additional downside risk to the lender, which are typically compensated for by higher expected returns. Accordingly, a higher default rate and loss given default rate relative to less aggressive, all-senior, lower levered loan structures should come as no surprise. And therefore, in the same vein, neither should more restructuring and enforcement activity on a relative basis.
Which factors will influence how direct lenders will act, and how will they do so?
To address the question of how we expect direct lenders to act, we need to consider why mid-market direct lenders will be motivated to take particular decisions. For illustration, we have where relevant below highlighted contrasts to the traditional banking market.
In line with the broader cashflow, secured lending community, the protection and enhancement of the value of investments and the wider business, for institutional and individual benefit, will be at the heart of all decision making.
The illiquid nature of the direct lending product limits a lender's loss-mitigation strategy for non-performing credits. The absence of this option to de-risk theoretically makes material security enforcement more likely for a debt fund if a satisfactory, consensual recapitalisation solution cannot be agreed.
However, for many fund managers faced with competing demands for asset management and focussed on value preservation, there will be an added motivation to achieve a swift, consensual solution through other means.
Fund structures and objectives
Debt fund managers will invariably be contractually - and financially - motivated through the fund documents to achieve a particular return profile for their limited partner investors on the basis of executing a particular strategy, and over a particular time horizon. Contrast this with a multitude of legal duties and listing rule requirements affecting traditional banks' decision making that will extend beyond a pure “maximising current shareholder value” concept.
Meanwhile, regulation in the fund world is typically light-touch relative to that governing traditional financial institutions. As a live example, the Financial Conduct Authority, the Financial Reporting Council and the Prudential Regulation Authority issued a joint statement on 26 March 2020, encouraging particular behaviours from relevant lenders in relation to the impacts on the financial condition of businesses from COVID-19 - such as waiver/amendment requests. That statement did not apply to debt funds. Regulatory capital constraints will also not presently shape debt fund behaviour in the way they would that of traditional lenders – although this will change with the taking effect in due course of the new prudential framework for investment firms (IFR) published in the Official Journal of the European Union on 5 December 2019. So the inclination to divest of non-performing loan positions will likely be lower for debt funds.
General partner carried interest
General partner carried interest, which can be a substantial part of a fund manager's compensation, will invariably require a hurdle rate to be achieved, over and above the return of invested limited partner capital. As default rates at investment level mount, it will become more and more difficult for those hurdles to be achieved.
This may encourage outcomes which will result in extraordinary gains, such as a debt-for-equity swap that offers upside turnaround potential, or freeing up capital to invest in other, higher-yielding, strategies such as liquid trading.
Reputation and relationships
Absent legal or regulatory constraints, preserving and enhancing reputation and relationships (institutional and personal) with key stakeholders will be a significant counter-balance to fund manager behaviours that might otherwise focus heavily on delivering short term returns for a particular fund.
A primary concern to fund managers – and their affiliated businesses, such as private equity houses – will be at investment level. Taking precipitous action against key sponsor portfolio investments or 'playing hardball' in stressed situations has the potential to limit severely future investment opportunities for the fund, affiliates and even the individual investment manager.
Conversely, failure to take advantage of senior secured status may harm its reputation and relationships at fund level with investors.
This can create a real tension, especially for those direct lenders outwardly professing to deliver to long term partnerships, patient capital and flexibility in bad times as well as in good.
Access to information and speed of execution
Debt funds will typically be in a position to execute a decision quickly relative to their syndicated lending bank peers, for a number of reasons, including:
- enhanced information rights and deal team members who may be directors or observers - independent business reviews will less frequently be required;
- the absence of a separate work-out desk; and
- being a sole - or at least controlling - senior creditor with little requirement to consensus-build.
A combination of: (i) a comparatively small number of investments and (ii) the illiquid nature of the product, which limits opportunities actively to manage portfolio composition over time, make private debt funds more exposed than banks to portfolio risks flowing from the occurrence of a particular event.
Ability to provide liquidity support
Debt funds will generally be less likely than banks to provide fresh capital on a standalone basis to businesses facing liquidity issues. Consequently, a sponsor/ shareholder in a debt fund structure is more likely to be encouraged at least partially to solve this need.
In such situations, debt funds may prove more flexible in allowing the introduction of more priming capital (potentially on an asset-backed basis) or providing other liquidity assistance (including through postponement of interest and principal payments).
Ability for debt fund to re-deploy capital
A restructuring solution which entails the early return of capital to the fund (and ultimately to the investor) will impact the level of return that can be generated for investors and carried interest, unless mitigated by call protection or swift redeployment.
Fund managers may therefore prefer to focus on options that allow existing capital to continue to generate income over immediate de-levering.
Fund financing arrangements
As portfolio performance dips, any fund level borrowings that contain a maintenance covenant calculated by reference to the net asset value of investments or asset coverage will be at risk of default. This could limit the availability of new funding, or even influence actions taken in respect of deployed capital (for example, to realise a prepayment).
The typical debt fund model of an originating team staying close to an investment through its lifecycle, with efficient processes and lean support functions, carries the multiple benefits of agility, accountability and a streamlined cost base. The challenges of this approach, however, will be more acutely felt as the portfolio experiences stress: limited internal bandwidth and restructuring expertise, as well as the opportunity cost of foregoing new opportunities in a less heated market, will necessitate trade-offs, and/or expense on external support.
It remains too early to say how these competing challenges will in many cases be balanced by debt funds, and the responses will necessarily be dynamic and idiosyncratic. However, in our experience:
- increased, and deeper, defaults do not necessarily translate into enforcement action being proportionately higher than in the bank world;
- where a bumpier road lies ahead, and/or sponsors or borrowers prove unwilling to engage pro-actively, we see debt funds using anticipated and actual defaults as the lever to open a dialogue with sponsors and borrowers earlier than a bank group might;
- consensual, bespoke solutions will generally be preferred (for direct lending strategy fund managers at least) and could take the form of recalibrating the capital structure and the risk/return profile of the creditors, potentially alongside a degree of involvement in a revised business plan;
- in more extreme cases of sustained under-performance, or faced with other creditor precipitative action or suspected fraud or misfeasance, as value breaks further into the debt and absent a satisfactory shareholder solution on the table, debt funds do exhibit a greater propensity to bring about a sale of the business or to take control of it; and
- the burden this latter approach will place on the investment team and/or the need to engage external advisors will act as a further deterrent to taking ownership in all but a small number of positions; expert turnaround / restructuring officer appointments may bridge any experience and bandwidth gap.
Direct lender reactions in focus: the COVID-19 global pandemic
The pandemic has acted as a catalyst for stress and distress in a way few could have contemplated. Our observations to date are that:
However, this episode will prove a first proper test for many relationships. One that will become more and more challenging the longer it takes for the post-C-19 landscape to take shape. Many businesses will emerge in a very different state and with very different prospects, to those contemplated when deals were originated.
When the dust starts to settle, and debt service and/or refinancing risks become clearer, fund managers will no doubt seek to re-visit the risk and return allocation between senior secured debt and equity on their deals. For some credits, insolvency could by then be the comparator.