Commentary: Delayed impact – private debt’s post-COVID-19 reckoning

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.

The resultant weakening of covenants was compounded by the way in which many unitranche funds structured deals by inflating EBITDA, allowing them to provide bigger loans without reporting higher intrinsic leverage. Ultimately, it meant that many lenders had found themselves in aggressive loans structures with fewer options when it came to maximizing their recoveries in an impaired credit.

Now, a range of funds now face a challenging future. As governments wean economies off fiscal-support measures and the hard realities of the economic crisis set in, many private debt providers may be left holding the bag.

Where default issues have arisen so far, both management and lenders are equally incentivized to delay their fates in the hope of a better recovery, adopting a kick-the-can-down-the-road approach to restructuring. But delay will lead to lower recoveries over the longer term, as struggling companies are still bleeding cash and face uncertain futures.

In fact, next year, this could result in the emergence of a large number of zombie companies, struggling to cover the significant debt piles, which will be a concern for those lenders who have not been willing to deal with issues in an upfront and open manner.

Some loans will already be marked on the books at a loss. These losses have already forced many direct lending funds, which still have significant dry powder to deploy, to search for less-cyclical credits to dilute the losses in their portfolios. But these less-cyclical companies do not need looser term sheets, given their natural stability, and place a greater focus on the price of debt.

This has squeezed the many unitranche lenders struggling to countenance the losses on pre-crisis loans, as they find it difficult to lend at yields in line with their fund targets to the strong non-cyclical businesses during the crisis.

A covenant trigger is an early warning sign that allows lenders to meaningfully engage with management and find suitable resolutions as early as possible — key to a successful outcome in direct lending. For too many loans in the market, the covenants are more accurately described as a last-minute notification at a time when lenders need all the warning they can get. That thinking leads to bigger losses in the long run.
Patrick Marshall is head of private debt and CLOs at the international business of Federated Hermes Inc., based in London. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.