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Special report: Outlook 2019

Private equity managers increasingly adding credit strategies

Ernst & Young’s Chris Le Roy

Industry executives expect to see an increasing number of private equity managers add credit strategies in 2019.

Many already have both private equity and credit, but increasingly credit is playing a bigger role in their businesses, said Chris LeRoy, New York-based partner and U.S. head of private equity for transaction advisory services at Ernst & Young LLP.

"Over the last year, we saw increasing pickup in credit opportunities and special situations businesses," Mr. LeRoy said.

These diversified private equity managers think of their credit divisions as "a feeder pipeline for future private equity deals," he said.

Many private equity firms are providing loans to founder-owned businesses, for example. And during the term of the loan, the private equity firm executives could approach the business owner to exchange the loan for a full or partial sale of the business, Mr. LeRoy explained.

And competition for deals among credit managers will only increase.

Business development companies, managed accounts and the business of lending to companies will remain competitive in 2019, said Anna Dodson, Boston-based partner, in the private equity group and the debt finance and financial restructuring practice of law firm Goodwin Procter LLP.

This is causing credit managers to reach into the middle market for deals, she said.

Credit managers are offering increased flexibility for borrowers in order to compete with other lenders such as banks and insurance companies. For example, managers now are offering revolving loan facilities, which allow borrowers to draw down, repay a loan and then take it out again during the life of the loan, Ms. Dodson explained.

Other examples of flexible lending include credit for voluntary prepayment of loans, default rates only charged for a limited time and credit terms allowing borrowers to deduct cash used in the acquisition. This flexible amortization allows the borrower to use its cash to support company growth rather than require the cash to be kept on the company's balance sheet to amortize the debt.

These loan terms are moving to the lower middle market, "which is notable," and they will continue to be offered to smaller companies in 2019, Ms. Dodson said.

"This does not change the way they (credit managers) underwrite the deals," said Fred Lim, a San Francisco-based partner in Goodwin's private equity group. However, the managers are willing to take on more risk by offering looser loan terms, Mr. Lin said.

Credit managers are getting larger — either organically or by acquiring other businesses or teams to expand their offerings, she said. So, credit managers are allocating term loans — loans for a specific amounts and repayment schedule — across different funds, she said.

However, deal flow likely will stay steady in 2019 with no massive changes either way, said Mr. Lim.

Theodore "Ted" Koenig, Chicago-based president and CEO of middle market private credit manager Monroe Capital LLC, said the pace of transactions should be strong in 2019, similar to 2018.

"Tax cuts have spurred more transaction activity because it has created more cash flow," Mr. Koenig said.

However, he added that Monroe Capital executives are "more careful in this environment," where interest rates have been so low for so long that "everyone is searching for yield."

Monroe Capital is investing now in a smaller percentage of the deals it comes across, he said.

"We won't do deals without good loan covenants," Mr. Koenig said. "Especially late in the credit cycle, we want to be more conservative."