We are often asked if investing in private debt had advantages over holding publicly traded bonds and loans during the recent market volatility.
Arguably it did, but we think it will really differentiate itself in the years following the crisis.
Before comparing the characteristics of private and public credit, it’s a good idea to define what we mean by those terms.
In this article, when we talk about investing in private debt or credit, we mean underwriting loans directly with companies and their private equity sponsors. By public debt or credit we mean lending in which arranging and syndicating banks play a prominent role, which subsequently gets traded on public markets—everything from high yield bonds and tradable bank loans to the tranches of collateralized loan obligations (CLOs).
Coming Into the Crisis
How did these compare coming into the coronavirus crisis? In our view, private debt had two potential advantages:
Because private lending is direct lending, every asset is unique. There is no investable benchmark. By contrast, the majority of high yield bond and tradable loan strategies are benchmarked against an index. In addition, many funds and mandates stipulate a maximum tracking error against the chosen benchmark.
That creates a strong risk-management incentive for public credit funds to hold many of the same assets as the index, at similar weights—even when there are doubts about the fundamentals of those assets. Some private debt portfolio managers certainly came into the COVID-19 crisis holding loans to companies in the worst-hit sectors, such as retail, leisure, restaurants, travel, oil and gas or autos. Others outperformed by deliberately avoiding these industries. But in all cases, every loan was an asset that they wanted to own rather than one they had to own.
The second advantage a private debt manager may have had was “dry powder.” A public credit manager is typically fully invested and invests new fund subscriptions immediately. By contrast, it generally takes a private credit fund around three years or so to invest its committed capital, so at any point in time there is a good chance that some client commitments remain undrawn. The recent period of tight credit spreads and unfavorable terms for lenders, combined with a very old credit cycle, may have increased the likelihood of being “under-invested” coming into the COVID-19 crisis, as private debt managers raised large funds but awaited more attractive opportunities. That dry powder was then available to invest in the post-crisis environment.
During the Crisis
How about once the crisis was underway, in March and April this year?
Public credit funds are exposed not only to the fundamental credit quality of the assets they hold, but also to other investors’ sentiment and behavior. In March 2020, the sentiment was panic and the behavior was a scramble for liquidity. Data from Lipper and JPMorgan indicate that U.S. high yield bond and loan mutual funds and exchange traded funds (ETFs) experienced huge outflows, followed, in the case of high yield, by a stampede back again in April and May.
As investors redeem from funds, fund managers are forced to sell their most liquid holdings, which pushes prices down, triggering more redemptions and more forced selling. Long-term investors not only get taken along for the ride: forced selling of quality assets purchased at attractive valuations in the past can also permanently impair performance.
By contrast, private debt investors are usually the sole or one of only a few owners of their assets, and all are providers of patient capital invested in loans that are generally held to repayment or maturity. There is little direct exposure to market panic or forced selling. Private debt investors can remain focused on how business fundamentals have changed, and that, rather than sentiment, will be the basis of any consequent write-down of portfolio assets. Did private debt funds lend to companies that struggled to meet their coupon payments during the COVID-19 crisis, or could fail to pay back principal over the coming months? Probably. But is it also probable that many of their assets have continued to pay current coupons? Yes.
The stampede back into public credit markets in April and May points to one thing public market investors can do, which is buy secondary-market assets opportunistically at fire-sale prices.
That’s not really an advantage over private debt investing, however, because private debt funds can use their dry powder to buy from the same fire sales. If private debt levels of yield are on offer for liquid first-lien loans, why wouldn’t they?
Moreover, while the COVID-19 crisis has delivered some spread-widening to investors, rapid and massive central bank intervention in credit markets dramatically shortened the “once-in-a-decade” opportunity one might have expected from such a deep economic shock. We think of 80 cents on the dollar as a good proxy for “stressed pricing” in leveraged loans. In the aftermath of the financial crisis of 2008 – 09, before governments and central banks had a crisis playbook, the S&P/LSTA U.S. Leveraged Loan 100 Index traded below 80 for 10 months. During the current crisis, it traded below 80 for just eight days (figure 1). Some assets are still trading at stressed levels, but take out highly exposed sectors such as retail and oil, and the volume is not much higher than it was pre-COVID.
Figure 1. The Deep-value Credit Opportunity That Never Was
S&P/LTSA U.S. Leveraged Loan 100 Index price, 2008 – 09 and 2020
Source: FactSet, Neuberger Berman.
After the Crisis
If COVID-19 was the deep-value credit opportunity that never was, that does not mean it has created no opportunity at all. We believe it has, in two different forms.
The first is in our view the lesser opportunity: helping damaged businesses survive and recover. This is socially important but risky work for lenders. It will involve identifying companies that are distressed but still viable, refinancing them, and reconfiguring their capital structures and possibly their business models. There is a high probability of failure, and it is easy for the interests of equity and debt investors to become misaligned: the former often seek to extend investment horizons to give more time for recovery, whereas lenders may prefer to recover principal as soon as possible. In any case, even after a shock as consequential as COVID-19, this is a small part of what private debt capital does.
The second, and in our view more compelling opportunity, is in meeting the first-lien debt financing demands of private equity leveraged buyouts (LBOs) in the post-COVID environment. There are three reasons why we believe this can continue to deliver high single- to low double-digit returns for private debt investors, but with much less risk: we think there is likely to be high and sustained demand for debt; less competition from other providers of loan capital; and a higher level of risk aversion among investors in general.
Supply, Demand and Appetite for Risk
The last five years, particularly 2019, were very successful for private equity fundraising (figure 2). But private equity dealmakers have been stuck at home for eight months. The net result, according to Preqin as of June 2020, is a near $500 billion heap of dry powder waiting to be deployed in U.S. buyouts. That will all need to be leveraged with debt to maintain the returns private equity investors expect. Private debt fundraising has been strong, too, but it has only kept pace with commitments to private equity.
Figure 2. Five Strong Years for Raising U.S. Private Equity Buyout Capital
Annual capital raised for U.S. buyout funds, $bn
As well as creating pent-up demand for leveraged lending, the COVID-19 crisis is also likely to lead to a reduction in supply. We have already seen the beginnings of this in a reduction of CLO issuance this year. CLOs tend to buy 40 – 70% of newly issued U.S. syndicated loans each year, so fewer buyers means fewer new loans being sold (figure 3).
Figure 3. Traditional Leveraged Lending Has Collapsed in 2020
Source: Standard & Poor’s LCD (Q2 2020 Leveraged Lending Review, CLO Global Databank).
We think this is due to investor risk aversion rather than loan underwriters and syndicators social distancing. Figure 4 also shows the impact of the global financial crisis on issuance between 2008 and 2012. It took five years for new loan issuance to return to pre-crisis levels. We think a shock as big as COVID-19 is likely to result in a similar multiyear aversion to risk among traditional lenders.
This general risk aversion tends to be good news for private debt investors, and particularly those focused on higher quality businesses and capital preservation rather than double-digit returns. Risk aversion means not only that traditional lenders may be less active and private equity sponsors may be more conservative with leverage; it also makes it less likely that private debt funds will compete for deals on risk, by offering the same yield to finance higher gearing.
Once again, the post-2008 experience offers an idea of what to expect. After hitting almost six-times EBITDA in 2007, the debt deployed in the average mid-market LBO fell to just three-times in 2009. Leverage stayed below pre-crisis levels for another three years (figure 4). Private equity investors wanted less leverage, but risk had also re-priced and made leverage more costly: yields maintained their levels even as leverage declined, and the premia for illiquidity and complexity arguably widened.
The net result was higher risk-adjusted returns to private lending. While acknowledging that the pandemic has created an unprecedented situation, we think similar conditions could prevail over the coming years.
Figure 4. Appetite for Leverage Declined After the 2008 Financial Crisis
Average debt-to-EBITDA ratio for U.S. middle market LBOs (<$50m of EBITDA).
Source: Standard & Poor’s LCD.
Conclusion: A Key Role in Private Equity Transactions
Let’s end by returning to our initial question: Were there advantages to investing in private credit markets over public credit markets during the COVID-19 crisis?
We believe there were, and they stood out even more than usual given the unusual nature of this crisis. Holders of bespoke, long-term investments, free from the tides of liquidity that swept through pooled credit vehicles, could look through the volatility of March 2020 and make a sober assessment of their portfolios’ credit risks. The re-pricing of publicly traded credit was deep enough for private debt investors to pick up bargains, but too fleeting to question the rationale of locking up capital in private markets.
Nonetheless, we think private debt is more likely really to differentiate itself after the crisis.
Deep-value and distressed situations will be rare and difficult, given official support to the economy. But, as other sources of lending are likely to be scarce, we believe private debt will maintain a key role in financing private equity transactions—and we think the combination of high demand and conservative attitudes to risk is likely to make that role well-compensated, even when lending to high-quality businesses.
A version of this article was first published in the Fall 2020 edition of Communiqué, the members’ newsletter of the Pension Investment Association of Canada.