Private credit — long investors' safer alternative investment — is getting riskier as capital floods the sector, with lending standards loosening and leverage increasing.
With private credit managers having roughly $600 billion in total capital, borrowers — typically private equity firms — have an increasing number of options to support their investments, industry insiders say.
In the past, a loan generally would be based on a percentage of a portfolio company's earnings. But lenders now are granting larger loans to borrowers in the expectation that future developments could boost a portfolio company's earnings.
That shift is making investments in private equity and private credit more risky, skewing private credit benchmarks and distorting the returns of some managers.
"I'm worried about the flood of (limited partner) capital," said Tom Cawkwell, San Francisco-based partner and head of private markets research at consulting firm Albourne America LLC.
Global private debt managers' assets under management totaled $605.5 billion — a combination of dry powder and unrealized value of invested assets — as of Dec. 31, up about $54 billion or 10% from Dec. 31, 2015, according to London-based alternative investment research firm Preqin.
But managers are set to add more capital to their coffers. There are currently 284 private debt funds aiming to raise a combined $112 billion in the market.
Limited partners increasingly are investing in some private credit strategies as they continue their hunt for yield. Some 32% of investors have allocated at least 6% of their total assets to private debt, with 17% targeting between 6% and 10%, according to an investor survey released in May by Preqin and Chicago credit manager NXT Capital LLC.
Investors are drawn to the asset class by the distributions of capital, with close to $100 billion returned to investors, and returns that have held their own against private equity. For example, 2008 vintage private debt funds have a global median IRR of 10.4% compared to 2008 private equity funds that have a global median IRR of 10.7%. While vintage year 2009 funds have a global median IRR of 9.5% vs 13% for 2009 vintage private equity funds, 2010 vintage private debt funds have a 10.4% global median IRR compared to 9.5% for the same vintage year private equity funds.
But, Mr. Cawkwell added, "the real risk is the amount of leverage in the transactions."
Lenders will add in "expected synergies" the portfolio company could achieve in the future, increasing its earnings, he said.
"Market participants are not incentivized to question. It makes the leverage levels look better," Mr. Cawkwell said. "It's a risk factor that is slowly building" and will continue to build unless it is managed by the industry."
What's more, loan covenants, which are supposed to protect lenders and their limited partners, are so lenient they have become meaningless, industry participants say.
"What we have observed is the mountain of debt that (private equity) portfolio companies are taking with close to no covenants," said Stuart Blair, director of research Canterbury Consulting Inc., a Newport Beach, Calif.-based consulting and outsourced CIO firm mainly serving endowments and foundations.
These loans go into technical default only when the portfolio company borrower misses payments, Mr. Blair said.
"There are absolutely no teeth to these securities," he said.
Outstanding debt backing private equity deals is also on the rise. Leverage levels in private equity transactions are up to pre-2008 levels, he said.
The median debt percentage for private equity deals was to 56.3% of enterprise value as of June 30, up from 50% in all of 2016, according to PitchBook Data Inc., an alternative investment research firm.
At the same time, the median price paid for transactions is higher than the amount paid in the cycle that ended with the 2008 global financial crisis. This means the average is well above that, Mr. Blair said.
For example, private equity managers paid an average of 10.2 times trailing earnings before interest, taxes, depreciation and amortization for middle-market businesses in 2016, surpassing the 10-year average of 8.8 times, according to S&P Capital IQ's first-quarter research review.
That amounts to a lot of risk lurking in investors' private equity and credit portfolios.