With competition increasing, risk levels are rising in private equity, real estate
Lenders in private equity and real estate are wheeling and dealing again, driven by competition to offer borrower-friendly loans with loose lending standards, few lender protections and contract clauses that can help hide portfolio company underperformance, industry executives say.
Foreign investors, banks and credit managers have capital to lend. Worldwide, private credit managers alone have a record amount of unspent capital commitments at their disposal — a combined $251 billion of dry powder as of June 30. In the heat of competition, lenders of all stripes are accepting fewer protections against losing money on loan defaults and allowing companies to delay revelations of trouble.
"Banks and non-banks are under pressure to write business," said Joseph R. D'Angelo, partner in the New York office of Carl Marks Advisory Group LLC, an investment bank that provides operational and financial advisory services.
That's not to say lenders have forgotten the pain they and their investors experienced in the global financial crisis, company executives say.
"There are definitely lessons learned," said Donald Sheehan, Boston-based managing director at Carl Marks. "How long do you retain those lessons before you do what is driven by the market? You have to put your money on the street (lend)."
Looser lending is occurring at a time when investors are leaning on credit strategies to be a less risky version of income-producing real assets and return-enhancing private equity. A downturn could not only slash performance of the ever-widening spectrum of private credit strategies, but also could lead to nasty surprises in investors' private equity portfolios.
"Covenants are important because they serve as an early warning system for lenders to identify possible problems," said David Fann, New York-based president and CEO of private equity consulting firm TorreyCove Capital Partners LLC. "They also give lenders certain rights to take actions to protect the (portfolio company) value and repayment of their loans."
Loosening of lending standards is driven by competition to lend, especially for private equity-backed deals, Mr. Fann said.
"Some of the interest coverage covenants and liquidity tests seem to have been negotiated away as (private equity firms) play multiple prospective lenders against each other," he said.
Capital is not only coming from non-bank, private credit lenders but also from banks that recently have started to get back into lending and are competing with direct lenders and foreign investors.
Worry about banks
Direct lenders' "biggest worry" is that banks are moving back into the business, said Timothy C. Ng, chief investment officer of outsourced CIO firm Clearbrook Global Advisors LLC, New York.
"Loan growth of big banks had 1% growth last year ... Loan growth in the second quarter was up 5.5%. That's a big move."
What's more, foreign lenders, including those from Canada, Germany, China, South Korea and the Netherlands are focusing on investing in credit, especially in real estate, due to U.S. tax advantages, industry insiders said.
Competition among foreign lenders to make loans are also helping to ease lending standards, said Diana Brummer, New York-based partner in the law firm Goodwin Procter LLP's real estate industry group. "For example, the spreads are so low in Korea to be almost zero. They are willing to cut deals to get their money out because the U.S. is so much better than their home country where they make almost no money putting out loans."
The proliferation of real estate credit strategies is pushing other lenders to relax their lending standards, she said.
"Lending is being loosened by real estate debt funds, which are putting pressure on traditional lenders," Ms. Brummer said. "Real estate debt funds are going to riskier places in the debt spectrum and it pushes everyone else along."
One way standards are slackening is that leverage on deals is going up, mostly by adding more mezzanine debt, she said.
"Loan-to-value has definitely gone up," she said. "The mezzanine pieces are often 15% of the deal plus 50% to 60% (of the deal in a) first mortgage."
And managers offering these riskier loans are not getting as high returns as they once had in exchange for taking on the risk, Ms. Brummer said.
"Spreads on the mezzanine loans are not as generous as you would think because there is so much money competing to make loans," she said.
Credit funds also are changing lending behavior in the real estate market, Ms. Brummer said. Lenders are now providing the entire loan, first mortgage as well as mezzanine and selling off the slice of debt they don't want after the deal has closed. This allows them to negotiate terms with the buyers of the debt, she said.
Jonathan Lavine, Boston-based co-managing partner at Bain Capital LP and chief investment officer of Bain Capital Credit, said he also is seeing credit loosening for loans for companies.
"We're seeing some late-cycle behaviors," Mr. Lavine said.
Borrowers' earnings numbers have "gone from likely (earnings) to possible to probable," he said.
"People are getting away with much more aggressive terms on the definition" of earnings before interest, taxes, depreciation and amortization, Mr. Lavine said.
The inclusion of "cure clauses" in loans also are providing borrowers longer periods to resolve, or "cure" any default, Carl Marks' Mr. D'Angelo said.
If the borrower pays the money that is in arrears, that will make the lender happy but "it does not mean the company's problems are being addressed," Mr. D'Angelo said.
What's more, Mr. Sheehan added, during the cure period, borrowers could also decide not to pay the amount that is in arrears on the loan. During the cure period, the company's financial health could have gotten worse, he said.
'An optimistic view'
In real estate, borrowers are not back to their pre-crisis projections of massive rent increases to justify loans, but they are basing mortgages on "an optimistic view of reality," Ms. Brummer said.
However, lenders are taking on more risk than investors might realize, said Tom Newberry, New York-based partner and head of private funds at CVC Credit Partners LP.
Credit managers are "a bigger and bigger piece of the market," Mr. Newberry said.
They increasingly are performing functions such as underwriting that used to be done by big banks, said Mr. Newberry, who worked for Credit Suisse Group LP during the financial crisis.
"Ares, Golub ... Highbridge are undertaking large-cap loans that used to be done by banks," he said.
They are holders of the loans and join together in a club to underwrite transactions and divide up the risk up front, Mr. Newberry said.
But the credit managers still are syndicating or selling off some pieces of the loans they are originating.
Investors at risk
"The people who are at risk are the (limited partners) of the fund" holding the loans, he said. "LPs may not understand that there is a chance they may be stuck with concentrated risk."
Indeed, Bruce Karsh, CIO and co-chairman of Oaktree Capital Group LLC, Los Angeles, noted during the firm's second-quarter earnings July 26 call that there's been "explosive growth" in direct lending over the past five years. "I think it's an area that is prime for having real issues over the next couple years" in part due to relaxed lending standards, he said.
Still, credit managers including those that do direct lending, say they are keeping their eyes on the risk they are taking.
"It's not lost on us that it's getting late in the credit cycle and enterprise values that are elevating won't be there forever and the growing economy won't be there forever," said David Richman, New York-based senior managing director at Guggenheim Partners LLC. Guggenheim has a $2.6 billion direct loan portfolio.
"It's not lost on us that we need to be conservative in what we are doing."