Navigating Private Credit Exposure: The Case for Specialty Finance

By Douglas Monticciolo, Brevet Capital

Our economy continues to face difficult liquidity challenges due to the severe and prolonged impact of COVID-19. As investors consider which private credit strategies are optimal in today’s environment, it is important to remember that our current financial crisis is vastly different from the global financial crisis of 2008.

In 2008, the crisis was due to a lack of liquidity. It provided opportunities for private credit managers with liquidity to buy distressed assets at historically low entry points, affording these managers a variety of ways to find value across the credit spectrum, which often led to outsized returns. The dramatic and rapid lowering of interest rates also facilitated a market recovery by making refinancing of overleveraged companies possible without the need for improved earnings or business models.

In contrast, the economic fallout from the pandemic was not caused by a financial collapse and corresponding lack of liquidity, but rather a fundamental collapse of earnings and business models. In less than one quarter, corporate bankruptcies have dramatically increased and business earnings have fallen dramatically. The most concerning aspect is that there is no clear indication or projection for recovery.

The continued economic fallout from COVID-19 has required companies to adapt new business models to weather the storm. Businesses with the vision to adapt to an evolving market will survive, but those that have been supported only by the low cost of capital are susceptible to fail regardless of their price of debt and how it is restructured. Lowering of interest rates and providing liquidity likely will not rescue these companies again. Some companies may get a lifeline from credit managers that have significant undeployed capital or raised large sums of money for distressed investment opportunities presented by the pandemic, but the fundamental question still remains, can earnings and business models rapidly recover the way they did in the last crisis?

As investors weigh their optimal exposure to private credit strategies, they should consider that distressed investing is often a risky bet dependent upon when and how a market recovers. Financing the recovery and its related economic development initiatives presents a more stable and more impactful opportunity. Since the outbreak of the pandemic, the Federal Reserve and U.S. Treasury have injected over $3 trillion into the economy. Financing the recovery means focusing on targeted opportunities that work alongside the government’s initiatives and have government payments or guarantees, reducing or, even eliminating, the uncertainty of predicting which companies can and will adapt and survive and which will not.

The Role of Private Credit in the Recovery

Private credit funds are expected to play a significant role in the market recovery, with many managers seeking to invest in distressed assets with hopes they will recover. However, it is important to remember that growth of this asset class in recent years has been accompanied by signs of increased risk-taking. Some of these warning signals have included leverage on deals surpassing 2007 levels, the proliferation of earnings before interest, tax, depreciation and amortization (EBITDA) adjustments based on potential future increased earnings and questionable add-backs, lack of restrictions on dividends and the relinquishing of critical collateral, and in general, agreements with few covenants protecting lenders. Just last fall, UBS credit strategists called traditional private credit “ground zero” for concerns due to the increased leverage on direct loans.

As managers seek to shore up their existing portfolios, many are attempting to mitigate performance declines by raising new distressed funds to take advantage of market dislocation opportunities and help restructure balance sheets. Such funds may be providing liquidity to companies that are restructuring their overleveraged balance sheets but may still have business models that may or may not survive the current crisis given the uncertainty around how long the recovery will take.

Focus on Specialty Finance

Companies with traditional business models face difficult third and fourth quarters as the reopening of the economy is expected to be slow and fraught with many interrelated complications and increased costs. Therefore, it is important for investors to focus on specialty finance, specifically, alternative credit strategies, that are substantially less uncorrelated to the broader economy, have strong capital protections and collateral and offer compelling risk adjusted returns in today’s market.

Among these niche strategies is a subset tangentially related to businesses that participate in direct federal and indirect federal backed state programs. Many of these companies have experienced better performance during the pandemic with the more stable guarantee of long-term government contracts at their core. Investment opportunities relating to these assets include solutions-based financing - generally in support of economic development and other goals of state, federal, and sovereign governments that serve the public good and help accelerate the recovery.

In Conclusion

Private credit mangers who maintained their discipline and had the foresight to avoid borrower-friendly private equity sponsor deals and correlated exposures, and alternative credit managers that are focused on capturing the opportunity created by the $3 trillion influx of government funds will ultimately be rewarded in the pandemic recovery with a rich opportunity set of transactions that have historically attractive risk and reward profiles.

Brevet Capital is a New York-based leading credit investment and specialty finance firm with a focus on the government sector. Since its founding over 20 years ago, Brevet has advised and structured more than $20 billion of transactions. The firm’s experienced management team has a successful track record of creating exclusive and often proprietary financing solutions for its partners that are sustainable through multiple economic cycles.

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