As with all crises, not all impacts are felt immediately. When COVID-19 forced countries into lockdown, businesses faced existential challenges. Company valuations and non-adjusted earnings dropped to a point where many loans were barely covered by equity, particularly in more cyclical industries. A natural conclusion may be a concomitant rise in defaults, but those have failed to materialize in the way one might expect.
The lack of defaults is the result of the most expansive program of peacetime economic support in nearly a century, delivering ample liquidity to small and midsize enterprises and other businesses. Though some sectors have seen a rise in defaults, it is not nearly as pronounced as could be expected in a pandemic given the scope and scale of lockdown measures and ongoing restrictions.
But a critical question remains: What happens when the fiscal taps are turned off?
To understand how turning off the tap could create a reckoning for some unitranche private debt investors beyond the clear economic ramifications, it is important to trace the market's growth back to the regulatory upheaval post-financial crisis.
It was after the 2008 crisis that the European private debt market established itself, as the new environment created more balance sheet constraints for banks. To fill this lending void, private debt funds stepped in with ever-growing waves of capital from institutional investors. The majority of these new alternative lenders focused on the unitranche product rather than the traditional senior secured loan product.
This newly expanded source of debt did not come without its challenges, the most significant of which was competition. As new entrants and funds joined the fray, yields tightened as lenders fought to deploy capital. Where a marginal gain on pricing was difficult to find, competition from the unitranche lenders came in the form of loan terms and leverage. This was particularly acute when it came to covenants, which are critical warning lights for lenders allowing them to initiate restructurings if the quality of credits erode.