Institutions seeing more private credit risks

Private credit may not be forming a bubble as fundraising slows and managers broaden their focus, but there are warning signs pointing to extra uncompensated risk lurking in investors' portfolios.

Portents of possible hazards ahead include:

• Leverage on deals surpassing 2007 levels.
• The proliferation of earnings before interest, tax, depreciation and amortization adjustments based on potential future increased earnings.
• Contracts with few covenants protecting lenders.

Institutional investors' portfolios have been growing for the last several years. According to Pensions & Investments' data of the 200 largest U.S. retirement plans, private credit assets grew by 62% in the year ended Sept. 30 and bank loan assets was up 25%, albeit from small bases in both categories.

"As rates have continued to go on a downward trajectory leading investors to seek more yield, the role of credit and private credit has continued to expand," said James Zelter, New York-based co-president and CIO of Apollo Global Management LLC's $215.5 billion credit business.

Private credit managers' combined assets under management grew to a record $812 billion as of June 30, up 78% from $753 million as of Dec. 31, 2018, and more than three times the $194 million total AUM as of Dec. 31, 2007, Pre-qin data show.

Despite dipping in 2019 following a record year in 2017, fundraising for private credit strategies remains strong. Managers of private credit have a record amount of dry powder, $297 billion, according to a McKinsey & Co. private equity report released in February.

"We continue to watch companies get as much debt as they are seeking," said Andrea Auerbach, a managing director and head of global private investment research at Cambridge Associates LLC in Menlo Park, Calif.

Credit managers are flush with capital and dry powder, she said.

"It still feels like it's go-go-go," Ms. Auerbach added.

Managers are competing to provide companies credit by agreeing to contracts with few lender protections and basing loans on EBITDA adjusted for potential earnings increases that have yet to happen rather than on actual EBITDA.

Ms. Auerbach calls it EBITDA Jenga because at some point all the pieces could come falling down. Industry experts estimate that 15% to 20% of EBITDA upon which loans are based could be overstated. In 2007, few loans were based on adjusted EBITDA, she said.

"If you are a savvy company or private equity sponsor you will play (private credit lenders) off each other," Ms. Auerbach said. "In the arms race to deploy capital, you get to see things in a different light."

Leverage used to invest in companies has surpassed 2007 levels, according to Cambridge data. Some 68% of investments carried leverage of more than four times EBITDA and 32% had more than six times leverage in 2017, compared to 61% of companies with more than four times and 30% with more than six times leverage in 2007.

Adding to the risk is that the loans to many of the businesses of a certain size are overwhelmingly covenant-light, meaning there are fewer lender protections, she said.

"As an investor in private credit, know your manager and its credit underwriting standards," Ms. Auerbach said. "Notice if the goal post has shifted over time."

Investors would be well advised to closely monitor EBITDA adjustments, said Stephen Nesbitt, Marina del Rey, Calif.-based CEO and CIO overseeing all investment research at alternative investment consulting firm Cliffwater LLC.

However, he added he has seen very little credit manager style drift. The exception is some movement among managers to larger deals, "a byproduct of asset gathering." Managers agree that in some instances EBITDA adjustments have gotten out of hand.

"There's no doubt there's been excesses from adjusted EBITDA and lack of covenants by certain players," Apollo's Mr. Zelter said. "Markets have evolved and its more competitive to put money to work."

Apollo's credit segment is by far its largest business, accounting for 65% of its total $331.1 billion in assets as of Dec. 31.

"The best firms have a real platform and a focused process. It is especially apparent when you go through a period of volatility like we are going through now," Mr. Zelter said.

"The traditional tools that we would use and include in underwriting are a deep understanding of the credit risk, the cash-flow generation ... and the competitive advantage of the company's business model," he said.

Apollo's affiliated business, MidCap Financial LLC, for example, has an experienced team that has been through credit cycles together, he said.

"They are quite disciplined in their approach. Ninety-nine plus percent of their loans have covenants," Mr. Zelter said. "Some newer firms are overexposed to 2017, 2018 and 2019 vintages and those firms may have some challenges."

And Mr. Zelter said that he does not see a bubble.

"There are periods of time where a lot of capital is chasing asset classes. Currently, there isn't a bubble. Deals are getting done," he said. "There's been asset growth in multiples in nearly every asset class."

Art Penn, New York-based founder and managing partner of private credit manager PennantPark Investment Advisers LLC, said EBITDA adjustments are a symptom of a later-stage credit cycle.

"People say it's a riskier environment and, in general, we agree with that," Mr. Penn said. "We've been saying for five years that you have to be careful and cautious. There's a lot of capital that has been raised resulting in competition."

Mr. Penn worked at Apollo before forming his own firm. PennantPark takes actual EBITDA and reviews line by line to determine whether firm executives are comfortable with the adjustments to EBITDA.

"They have to be easily achievable within the next three to six months and it has to be an item without a lot of execution risk, such as optimizing human capital," he said.

PennantPark competes with about 100 lenders including private credit funds, business development companies, collateralized loan obligations and specialty finance companies.

Club deals in lending are common. "One day we are competing, the next day we're sharing a deal," Mr. Penn said.

Meanwhile, he said that his firm keeps leverage reasonable.

"For us, reasonable leverage on underlying portfolio companies is 4.5 times debt to EBITDA for a senior lending portfolio. The market is 5.5 times or higher," he said.

What's more, credit is developing into a broad asset class and includes sectors that are less competitive. Apollo's credit business includes everything from its $63 billion in fixed income to $18 billion in residential real estate and consumer loans to its insurance solutions group.

"While the market has grown, we think there is an evolving opportunity. It's our view, and investors believe, there is a broader set of opportunities that go beyond middle-market sponsor finance that include aircraft financing, asset based loans … litigation finance," Mr. Zelter said. "We want to do public and private and to do primary, secondary and origination, especially in periods like we are living through today."

Cliffwater's Mr. Nesbitt said: "There are certainly parts of the market that are more crowded than others but generally the private credit market is very diverse."

That said, middle market remains a very popular spot for managers. "The sponsor lending market targeting companies with $25 million to $50 million of EBITDA ($100 million to $300 million tranche sizes) I would argue is the most crowded part of the market and one could make the argument that many managers in this space are competing for the same deals," Mr. Nesbitt said.

Managers crowded into the middle-market lending market because funds ranging in size from $500 million to $1 billion with a total levered portfolio of about $2 billion can be properly diversified if they join with other lenders in the transactions, he said.

"These funds can achieve an economic sweet spot in terms of fees" attractive to investors and managers, Mr. Nesbitt said. And loan sourcing can be efficient as long as the credit manager has a broad roster of private equity manager relationships, he said.