When Blackstone‘s private debt arm reached a $4.5 billion close on its second European direct lending vehicle in March, the achievement was soon overshadowed by larger events—just three days later the UK, along with much of Europe, was in full lockdown.
2020 had been off to a strong start, with two other sizable direct lending funds reaching a close in the weeks prior: Ardian closed on €3 billion (about $3.6 billion) for its fourth flagship credit fund, and its US peer Churchill Asset Management gathered $2 billion for its second mid-market fund.
Deploying capital over Zoom isn’t the only new challenge facing these managers. In addition, they must steer funds of a relatively new asset class through uncharted waters in the face of unprecedented economic headwinds. And despite fears of the private debt industry’s exposure heading into this year, so far there are few signs of serious trouble.
To be sure, significant concerns still loom large. Few of today’s private debt managers have a track record of weathering a severe global downturn. Most of the active firms got their start after post-2008 regulations pushed traditional commercial lenders out of the market. Moreover, a decade of loose loan requirements has left some managers, and their borrowers, overexposed if faced with a market reversal.
How managers navigate their portfolios through the pandemic crisis—by minimizing defaults and seeking new opportunities—is expected to shape how limited partners will allocate capital to private debt for years to come.
In a sign of growing pressure on fund managers, some debt funds are already focusing their deals on more conservative bets, splitting the market into haves and have-nots.
“What you’re going to see, I think over the next few months, is a lot of people trying to do deals in the very safe sectors, which means yield will be very tight in that part of the market because of the defensiveness of these companies,” said Symon Drake-Brockman, a managing partner with London-based private debt investor Pemberton. “But some people will be very willing to be flexible on documentation because they’re just desperate to get some money to work. We think you will need to be selective.”
Overall, debt-focused managers’ fundraising slowed down considerably this year. In the first half, 53 funds raised a total of $47.8 billion—far less than the $68.2 billion raised in the same period a year ago, according to PitchBook’s H1 2020 Global Private Debt Report. Deal activity was down, too. Just 2,335 debt investments were made globally in H1, the lowest count in a six-month period since at least the start of 2015.
“For the first month or so [of the pandemic], private equity and private credit firms were performing triage on their portfolios,” said Randy Schwimmer, a senior managing director at Churchill Asset Management. “Like a hurricane coming through, you head for shelter, then emerge later to assess the damage.”
So far, private debt managers and their investments, on the whole, have been resilient, as demonstrated by the relative lack of defaults. According to Proskauer, a law firm that tracks private debt loans in the US, the default rate for Q3 was 4.2%, down from 8.1% in Q2 and lower even than the 5.9% rate in the first three months of the year.
Many borrowers were able to rely on existing revolving credit facilities to see them through the lockdown. This type of credit allows portfolio companies to withdraw money, repay debt and withdraw again on an ad hoc basis. Some companies also had the additional support of their private equity sponsors.
“Private equity backers were injecting equity into businesses that needed it and negotiating with lenders to provide companies enough room to operate without tripping a covenant,” Schwimmer said.
Nevertheless, loans issued on borrower-friendly terms in the overheated market that preceded the crisis still may have left lenders vulnerable. In the credit markets, such “covenant-lite” deals are essentially unfettered lending agreements that give borrowers wide latitude. While covenant-lite loans have been less common in mid-market private debt, so-called covenant-loose loans, which have fewer protections, have been creeping in. These loans comprised 59% of deals the firm’s clients completed in 2019, according to Proskauer data.
“I think some of the managers were quite aggressive in trying to win deals on terms, and they gave away a lot of control in the deal to the sponsors,” said Pemberton’s Drake-Brockman, who added that his firm averted distress in its portfolio because their covenants made it less likely that borrowers would default.
Whether a company defaults isn’t simply a result of how strict managers make their deal terms. The unprecedented way in which the pandemic has hurt some sectors more than others has meant companies that would have otherwise weathered a conventional economic downturn have disproportionately felt the pain. Meanwhile, some industries have been better insulated.
Private debt investors exposed to travel, hospitality and especially retail have been the biggest losers after being shuttered during lockdowns. A number of US retailers backed by private equity firms went bankrupt, among them J. Crew and Neiman Marcus.
Cécile Lévi, head of private debt at Paris-based Tikehau Capital, said she expects the market to become even more bifurcated than it already is today. More capital will be raised across fewer funds as LPs concentrate on managers who bet on safer industries or those that are large and diverse enough to absorb losses.
“I think that there will be further consolidation in the market,” Lévi added, “or at least there will be managers struggling to raise new funds.”
In the meantime, distressed debt managers will also be looking for more opportunities. This year has seen a larger share of overall capital raised going toward distressed debt funds. Together with special situations vehicles, the strategy accounted for nearly 30% of fundraising in the first half of the year, compared to just 19.7% for the whole of last year, according to PitchBook data.
Not only is Oaktree Capital in the market with a new $15 billion distressed debt fund, but Apollo Global Management‘s $24.7 billion Fund IX has shifted its strategy from buyouts into credit and distress-for-control opportunities in May. The firm is looking to raise an additional $20 billion for COVID-19-related distress opportunities in the coming year.
“There’s been plenty of capital raised for higher-yielding distressed debt targeted at companies impacted by COVID where existing lenders are looking to exit,” Churchill’s Schwimmer said. "[But] those opportunities haven’t surfaced in numbers because lenders and private equity sponsors are working closely to keep liquidity in these businesses going.”
Featured image via Oscar Wong/Getty Images
Note: The chart in this story was corrected on Dec. 14 to accurately reflect the size of Apollo Strategic Origination. The fund size is $12.53B not $2.53B as previously reported.
