Investors discover some weaknesses with private credit

Private credit investments were sold as lower risk than equity strategies, with some types of credit such as distressed debt considered defensive, but the COVID-19 crisis makes those performance expectations an open question, industry sources said.

Credit managers today are having to deal with investments predicated on the good times continuing in a growing economy awash in cash. Such firms had competed for deals by requiring fewer — if any — covenants, offering looser fund terms and lowering their own return expectations. Now, for the first time, they are talking with borrowers, many of which are private equity firms' portfolio companies, about forbearances, restructuring loans and covenant waivers, and making other accommodations to lessen the likelihood of defaults.

"For some time now, we have been saying the next downturn would be a liquidity-driven downturn and COVID made that true in ways we never expected," said Kipp deVeer, director, partner and head of the credit group at Ares Management Corp. Ares had $110.5 billion in credit assets under management as of Dec. 31.

"Across the market, we see companies running into liquidity challenges," said Mr. deVeer, who also is director, CEO of Ares Capital Corp., the firm's business development company.

Many investors are in a good news/bad news situation. While the dislocation and illiquidity in the markets offer some attractive near-term private credit investments for their portfolios, existing credit portfolio returns have likely fallen as much or even more than those of their liquid credit investments.

Private credit as an asset class was created in the aftermath of the last recession. But the ongoing uncertainty surrounding the duration and severity of the current crisis is making it difficult to analyze the impact of long-term credit investments on investor portfolios. Reporting lags as well as significant dislocation of the public markets that serve as a reference point are making valuations difficult.

"Quite honestly I think it is too early to tell whether private credit is an effective defensive strategy," said Michael Granoff, New York, CEO of Pomona Capital. "It has not experienced the kind of dislocation that is currently occurring across the credit space."

Also like most other asset classes the conclusions may not be uniform, as there will be private credit players who outperform and players who underperform, Mr. Granoff said.

"It is now a material part of the private equity universe and Pomona is monitoring it closely," he said.

Private credit fundraising had just completed its best three-year period in history, having raised $388.9 billion globally since 2017, according to PitchBook. Dry powder was up to $276.5 billion as of June 30, PitchBook data shows.

Private credit earned an annualized internal rate of return of 5.9% for the year ended Sept. 30 and annualized returns of 8.9% for the three years, 6.7% for the five years and 9.20% for 10 years, according to the most recent data from London-based alternative investment research firm Preqin.

Officials at the Los Angeles County Employees' Retirement Association, Pasadena, expect to make additional credit investments to access opportunities, according to the March 18 report by CIO Jonathan Grabel to the board.

LACERA has a 3% target allocation to illiquid credit. LACERA is underallocated to illiquid credit by $1 billion, and officials plan to build out the portfolio soon at attractive prices, he said in the report. LACERA has $530 million undrawn capital commitments to existing illiquid credit managers and is in the late stages of due diligence with two more illiquid credit managers, Mr. Grabel said.

In the report, Mr. Grabel estimated that the illiquid credit portfolio could have dropped 7% to 10% in the first half of March. LACERA had $916 million in illiquid credit as of Nov. 30, the most-recent data available.

"In drawdowns that include a widespread decrease in investor risk appetite (such as in early March), illiquid credit portfolios can decline as much or more than public credit/equity markets," he said.

Private credit is perceived as lower risk than equity and a substitute for some forms of corporate fixed income such as high-yield notes and bonds. Private credit is intended to protect against rising interest rates and serve to diversify portfolios. And some strategies, such as distressed and rescue financing are intended to be defensive, said David Fann, New York-based vice chairman of alternative investment consultant Aksia, LLC. "It turns out there are very few places to hide in a pandemic," he said.

Some credit managers and investors expect that the market dislocations could result in attractive investments that will boost returns. There are several distressed vehicles being activated or raised, Mr. Fann said, but he declined to give specifics.

At the start of 2020, there were 436 private credit funds in the market seeking to raise $192 billion. In addition, several credit managers have recently raised funds with capital to spend for distressed and stressed companies. In February, for example, Angelo, Gordon & Co. closed its flagship fund aimed at investing in distressed and corporate special situations, AG Credit Solutions Fund LP with $1.8 billion.

The big question is how long the COVID-19 crisis will last and the amount of government intervention. So far, government actions have kept the capital markets functioning, he added.

While each of the asset class directors of the New Mexico State Investment Council are searching for opportunities in the current dislocation, most of the opportunities are centered around credit, said Robert "Vince" Smith, CIO and deputy state investment officer at New Mexico State Investment Council, Santa Fe, which oversees $23.9 billion in endowment assets.

The credit space is where a lot of the opportunity seems to arise, both investment-grade public credit and in private credit, he said. The council made commitments of $100 million each to two credit contingency funds — Silver Point Distressed Opportunity Institutional Partners and TPG Sixth Street Partners' adjacent opportunities fund — in 2018 that would not draw down capital until the managers saw an investment opportunity, he added.

Ares' Mr. deVeer said that the lack of liquidity for companies is leading to investment opportunities, including in companies that are not suffering from cash flow problems but are nevertheless taking out loans as a type of "insurance" for future cash needs in the event of an extended recession.

"As a result, we are seeing significant deal flow from rescue situations," he said. "Also, we have been in touch with some companies that are not in the directly affected industries, yet are still willing to pay for insurance."

Ares Management had $34.6 billion of available capital at the end of 2019.

Liquidity is a big issue for private equity firms and their portfolio companies, which is good for investors' new credit investments, said Doug Cruikshank, New York-based head of fund financing at Hark Capital, a business of Aberdeen Standard Investments. Hark Capital provides loans to private equity firms based on the net asset value of their funds.

Even so, there will be winners and losers among private credit managers, he said.

Loans based on so-called EBITDA add-ons, which is when actual EBITDA numbers are increased based on possible future earnings, and loans with few covenants to protect lenders will have a greater impact on credit returns than in the last recession, Mr. Cruikshank said.

The reason is that in the years leading up to the current crisis there were a lot more loans issued by private credit managers with fewer covenants and earnings based on potential future cash flows. As a result, the damage to investors' portfolios is likely to be "worse this time," he said.

Mark Attanasio, Los Angeles-based co-founder and managing partner of credit manager Crescent Capital Group LP, said that EBITDA add-ons, also called pro formas, were up to 40% over the prior year's cash flow. Some deals had both pro forma adjustments and leverage multiple creep — with bank loans up to six times a company's earnings from about three times in 1993, when Crescent started managing bank debt.

"In these cases, companies with (seven to eight times) pro forma leverage were financed at (10 times) prior-year cash flow," he said.