For all intents and purposes, deal activity has stalled amid the Covid-19 uncertainty. That doesn’t mean, however, that all lenders are necessarily sitting on their hands. While for many borrowers, accessing recently announced government funding has proven challenging, certain participants in the private capital markets will step up to provide a port in the storm.
The good news is that private credit has been here before. In many ways, the global financial crisis in 2008 served to accelerate growth in private credit. The asset class has since emerged as the type of patient capital best suited for a dislocation such as the type the market is experiencing today.
The catch, at least for borrowers, is that the market has grown so much over the past 10 years that it’s often difficult to determine, due to the sheer size of the credit universe, which lenders have the capital and are willing to step into the breach. Further, how will these lenders assess and manage known threats, and to what extent they require high levels of compensation for accessing the scarce liquidity in the market and for potentially absorbing heightened risks in a market with so much uncertainty.
A disruption unlike any other
While the global financial crisis of 2008 provides valuable perspective, the differences between the two “black swan” events are notable. During the last recession, for instance, there was an economic slowdown that reflected on company financial statements by a normal, if not extreme, progression in which revenues and earnings generally declined over a period of time. This measured cadence of contraction allowed creditors to model out potential economic troughs and to determine when and to what extent a rebound might occur. Today, in contrast, certain sectors have experienced a complete and total cessation of business activity, in which affected companies went from peak revenues to zero, virtually overnight.
There is no playbook for lenders, borrowers, the government, or even individuals in how to respond to a pandemic. And the virus itself remains a mystery in terms of who it affects, how it will morph, and whether herd immunity will ever take hold. Taken together, this uncertainty creates a very fluid and unpredictable foundation on which to assess risks when putting capital to work.
If there are applicable lessons from the past, it’s that liquidity is key, attentive engagement is critical, portfolio management is crucial in times of crisis, and access to dry powder can enable an offensive approach. The takeaway for borrowers is that there will be a premium for capital, but longer-tenured lenders will seek to be collaborative partners. However, there are certain considerations for borrowers in such an illiquid market.
Know your lender’s strategy
The traditional cash flow lending market will return. But at a time when the House antitrust chairman is calling for a blanket ban on all mergers, it should be crystal clear that these are extraordinary times. Beyond just the pandemic-related risks, the recessionary threat is turning the attention of most cash flow lenders inward to focus on their existing portfolios. Commercial banks, as most borrowers know, are constrained by their reserve requirements, while other alternatives, from hedge funds to high yield mutual funds, are themselves facing liquidity threats as redemptions mount.
Generally speaking, this winnows the field to distressed and special situation investors and opportunistic credit funds, both of whom have the skillsets to put capital to work in these markets. Most observers tend to think of these specializations as comprising one all-encompassing category, overlooking the significant differences between the two strategies.
Perhaps the biggest distinction is that most distressed strategies are effectively market-timing plays, whereas opportunistic credit positions itself as an all-weather strategy. The latter can invest in good times, through embracing complexity to put capital to work (think specialty finance, structured real estate and other more complicated credits). But in more challenging markets, opportunistic funds will seek to amplify returns as a provider of liquidity through secondary purchases or rescue financing arrangements underwritten against financial and hard-asset collateral.
Recognize their appetite
The distinctions, of course, help inform the appetites of the two strategies. Distressed managers, for instance, are often deep value investors, who may be willing to bet on sectors with little if any clarity. They may also have far different motivations, particularly if they’re pursuing loan-to-own plays that has them angling for control equity through purchase of the fulcrum security in a distressed deal. This is in contrast to opportunistic strategies that might use the dislocation to capitalize on an opportunity to buy mispriced credits and accumulate performing first-lien loans at a significant discount to par.
Moreover, some all-weather opportunistic strategies were already avoiding efficient, cyclical sectors, such as autos, retail and hospitality. Given their exposure to Covid-19, these areas have become even more difficult to gain any comfort, but sectors expected to come back once the markets return to normal – media and events, business services, software and SaaS – are more attractive to opportunistic funds.
Appreciate their constraints
The biggest challenge for all participants in M&A right now is that the market is stuck in suspended animation. To put this into context, if a mid-market lender had 15 signed deals in the pipeline pre-Covid, all but two or three probably would have been put on hold. The rare deals that were able to proceed were by and large PE-backed accretive tuck-ins in safe haven sectors. But other than these exceptions, investors are struggling to price risk in such an anomalous market.
Lenders with a more flexible investment mandate will use pricing in the secondary loan market as a baseline, otherwise, new financing arrangements are being underwritten against hard assets and collateral. This can include everything from real estate or IP and royalty streams to accounts receivable or litigation claims. In one recent deal supporting a PE-backed healthcare operator, the loan was underwritten against an 80% advance rate on accounts receivable.
Remain flexible and embrace creativity
Another key distinction between distressed investors and opportunistic credit is that the latter requires a relationship driven approach. At Monroe, for instance, we’ve been pursuing our opportunistic strategy out of a sleeve in our traditional private debt funds for over a decade, and only recently created a dedicated fund for these investments. But the strategy was born out of efforts to customize our relationships around the needs of borrowers to find win/win solutions that work for both sides.
The same way we are making accommodations for existing borrowers, we’re finding new opportunities to forge relationships with corporate borrowers, real estate funds and even credit-oriented hedge funds to step in and help these businesses bridge a funding gap. These are otherwise healthy businesses with high-quality assets unlikely to experience permanent impairments, but they require short-term liquidity to avoid more desperate actions.
Ten years ago, private debt at best might have garnered a 1% or 2% allocation within an asset owners’ total holdings. Fast forward a full credit cycle later, and institutional investors are now carving out 15% to 20% allocations, reflecting the consistency and uncorrelated returns of the asset class. This environment in particular intensifies the need for patient, thoughtful capital and all-weather, opportunistic strategies should emerge as a reliable niche within private credit. In an environment with so little clarity, it’s one of the few alternatives that can find conviction to act.