Commentary: Private debt as the new private equity amid COVID-19

The marketplace has been top-cycle driven for quite a long time, and most private debt industry professionals and institutional investors have been wondering what the catalyst will be for this decadelong ride to finally end. To most people's surprise, the catalyst we find is a health-care crisis curve ball called COVID-19, and not a Middle East war or, more practically, consumer sentiment and spending fading away.

As we fight for our health around the world, we are intentionally — and necessarily — closing businesses, which in turn has reduced liquidity in the financial markets and put potential stress on private debt portfolio allocations. Not all strategies have been created equal, though. Non-first-lien loan, levered loans and structural leverage strategies may cause additional stress in the current uncertain environment.

These strategies, which are lower in the capital structure and include mezzanine, senior secured last out, and other subordinated loans, are at greater risk. As equity valuations get a haircut, the subordinated or junior debt will either be fully eroded, or, in the best-case scenario, become the new equity so long as the junior debt brings something to the table (most importantly liquidity in the form of fresh capital).

Most direct lending managers that provide leverage to private equity-backed businesses (also called sponsored lending or leverage loans) underwrite to the hope that the financial sponsor will typically back their portfolio companies most of the time, in addition to usual credit metrics. The average credit metrics for sponsored lending include an aggressive leverage ratio as a multiple of EBITDA (typically five times on an adjusted basis), five-to seven-year duration, non-amortizing structures, limited to no financial covenants coupled with long cure periods, and the pricing of risk is predicated on the financial sponsor's backing vs. actual credit risk.

The untold story is that many of these businesses have extremely tight cash flows at the time of underwriting and there is very little margin for business operation error. A particular company may be generating $25 million or $50 million of EBITDA on an adjusted basis, but when one takes away the adjustments, interest rate coverage and other normal business expenditures from the EBITDA, the cash flows of the business are razor thin (think $5 million of cash flows at best for a $25 million EBITDA business).

Given today's environment during the COVID-19 outbreak, whereby revenues and overall business activity is dropping significantly, most of these highly levered balance sheets will realize negative cash flows. While this circumstance may not even trip a financial covenant, something needs to give, and either the private equity sponsor or the lender will need to make a cash infusion to the business in the form of a dilutive equity or protective advance from the lender. Tough conversations will take place between the sponsor, management of the portfolio companies and the lender. Some conversations will be smooth, while others will be highly acrimonious. Depending on the depth of the downturn, the cracks in both the relationship and, most importantly, cash flows will most likely deteriorate.

One important question to ask is what will the leverage ratio on EBITDA be at the end of 2020 for most of the sponsored loan market? If the starting point was five times (with adjustments), I suspect that average will creep up to eight times, or maybe even nine times leverage, which are levels that approach equity multiples. LIBOR compressed down to sub-1% and spreads at or about 5.5% speak to a 6.5% yield for equity risk. From a valuation standpoint, par loans will need to be priced about 80 cents on the dollar to rightsize the value for a senior secured levered loan.

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.