As discussed above, many strategies have a highly levered capital structure to begin, and on top of credit leverage, managers will tack on structural leverage. Think of business development companies or sponsored lending strategies that offer a levered share class promising double-digit returns. Well, if one of the credits in a portfolio has a casualty, the structural leverage will automatically make it a double hit. In the worst of circumstances, if there is significant amount of credit deterioration (for example, BDCs are trading at a 30% discount to book value), then the leverage providers, which are primarily banks, will require such managers to infuse more equity in their businesses (think of it as a margin call). If liquidity isn't available, we need only look back to the not too distant history of 2008 to get a sense of what types of ruthless, self-serving behaviors that could ensue.
So what can institutional investors do to protect their portfolio investments?
One novel idea is for these managers to create a side pocket with existing limited partner commitments to provide liquidity to their portfolio company investments in the event the equity doesn't step up. This puts the subordinated investor in a competitive advantage to potentially dilute the equity and step up with additional capital. The hierarchy of the debt capital structure, whomever places additional liquidity into the business, will either justify their position in the capital structure, or trump the junior lenders and equity.
This investment can be viewed as a distressed or special situation vehicle whereby the sole mission is to save legacy investments vs. performing this same task for other investments that the LP has no connection with.
When we finally come out from under the dark cloud, there will be several important lessons to be learned:
- Did private debt managers price risk appropriately by providing leverage to private equity firms?
- Was striving for double-digit returns by subscribing to funds with structural leverage prudent?
- Does being sandwiched inside a capital structure (mezzanine or junior capital) really create a no-man's land, or essentially equity without the upside?
- Will private equity firms back all of their portfolio companies as they've been promising?
The jury is still out and the night is young. However, one thing that history and finance lessons will remind us is that relying on gravity is akin to a hot air of false hope; no one can defy gravity for a prolonged period of time. In times like these, many of the marketing brochures can be shredded. Facts and charts have been commissioned to paint one perspective that fulfills a commercial agenda, but does not account for the market we see today. In the coming quarters and years, there will be winners and losers. The unfortunate reality is that this new sector we call private credit will most likely be painted with the same negative brush. That said, in the best-case scenario, investors will deem private credit investing as the new private equity asset class.
Andre Hakkak is CEO at White Oak Global Advisors LLC, San Francisco. 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.