As the market continues an unprecedented eight-year M&A and stock market bull run, people continually ask where the economy is in the business cycle—what inning?—and whether it is closer to the end of the game than to the beginning. No one has the crystal ball to pinpoint the exact moment when the euphoria will turn to fear. Yet two things are certain: history repeats itself and cycles happen.
One need not read history books to see the truth of that statement. Cycles happen all the time. The tech bubble of the early 2000s, the Great Recession of 2008-09, and the oil collapse in 2014 are all recent examples. Cycles are part of the economy, and at no point in history has the economy been immune to them. Those who choose to ignore history will suffer the consequences when the music stops—investors should beware.
If everyone knows, or should know, this and has seen this game end poorly before, then why do they remain involved with the market entering into areas they know are risky—riskier than the pre-Great Recession period? Simply put, it results from the nexus of greed, the search for yield, and poor alternatives.
Several tailwinds have supported the credit markets since 2010. Interest rates have been at all-time lows, banks have voluntarily exited or were regulated out of the system through the Dodd-Frank Act/Volcker Rule (and essentially limited to just asset-based lending), and the search for yield for limited partner (LP) capital has provided an abundance of dry powder to private equity shops that need to put it to work. Moreover, the perceived “safety” of credit, since it withstood the Great Recession better than equity, attracted LPs into the space and opened many people’s eyes for the first time to private credit, even though the product has been around since the late 1990s.
To fill the void left by the large banking institutions, firms that have trafficked in direct lending for decades were looked to as the experts in the space. They raised capital at a feverish pitch post-crisis, scaling from a few billion-dollar funds to multiples of that within a year or two. More than 20 firms now lead with their checkbook size, though it once provided a competitive advantage for just a few.
Moreover, even though business development companies (BDCs) have been around since the late 1990s, they have raised capital at a record pace, and the sector now includes new entrants who purport to know how to lend money but are new to the space. The combination of a massive amount of equity waiting on the sidelines and the immense amount of capital in lenders’ hands—juxtaposed against the aforementioned macro factors involving interest rates, regulation, etc.—filled a powder keg for activity.
This began fueling the desire to increase LBO activity, thus creating a feeding frenzy for buyers as valuations have continued to rise (justified, since public comparables have risen in concert with the stock market, hitting new highs). To justify returns, a private equity shop would now need to increase leverage levels or put in less equity to enhance its yields. Direct lending entered the picture.
Why would lenders do this when the memory of the Great Recession is so fresh? The simple answer is that the model has changed. Today’s post-crisis debt funds are paid only on deployed capital, not on committed capital. In other words, to keep the lights on, an investor must deploy capital to earn a management fee (not to mention the future incentive). That’s a far cry from the days when managers could remain patient and still generate fees to pay their people.
The siren song of managing billions of dollars—despite lacking a strong track record of investing developed over many years and through several cycles—has created a misalignment of interests, where many fund managers can’t resist deploying assets quickly to continue to raise more money to deploy (and repeat). Many ignore prudent credit discipline along the way so they can generate fees to pay themselves and their teams. When managers are highly incentivized to deploy large amounts of capital sooner rather than later to earn fees, things generally turn out poorly over the course of time.
When a “food fight” over deals ensues among fund managers, people take shortcuts to win. They may embrace higher levered capital structures, watered down creditor protections (covenant-lite or covenant-loose), loose financial definitions, and the newest craze to hit the market: diligence-lite. Lending is not rocket science, and while no one begrudges someone making money in a capitalistic society, credit typically shares in one fluctuating area of the investment—downside only.
Credit 101 teaches that downside protections are all that protect lenders (and their LPs) from catastrophic losses. Despite that, leverage is at nearly six times forward EBITDA or even seven times or more on some deals.
Leverage is just the tip of the iceberg. Covenant-lite loans come up in discussions all the time but fundamentally are not well understood. Covenant-lite loans lack financial maintenance covenants and provide a borrower greater flexibility to take on more debt (at times pari passu or senior to existing debt), extract cash from the company, and limit the lender’s access to management.
Smart LPs have started to question the funds they have or those they are considering for investments about how many of the firms’ loans are covenant-lite. But a better question or follow-up is this: how many of the firms’ loans are covenant-loose? A covenant is included in such loans, but it’s set so wide of management’s plan—with more than 40 percent cushions—that it might as well not be there. A company that trips such a covenant might as well just hand over the keys to the business to the lender.
Finally, one should check the definitions in the credit document to see how a simple metric such as EBITDA is defined. If the definition is longer than a paragraph and includes a long list of addbacks, plus the aforementioned 40-plus percent wide of plan metrics, one should be wary, and they should be even more guarded with regard to diligence-lite loans.
Naysayers might ask, who cares? And in the short term they are right, as long as 2 to 3 percent global growth continues and interest rates remain low. One simple reason the industry should care is that LPs like this product because of its perceived safety; through the last recession it fared better than private equity. When modeling out low single-digit to double-digit yields and factoring in history, how can one not love this profit?But there is a problem. The funds advancing capital to these borrowers this time around aren’t banks. They are led by lawyers, traders, or individuals from the capital markets. In other words, they are headed by folks who may not fully appreciate what they are giving up now that may crush them later. They have a different mindset and, frankly, are not set up to handle a downturn the way banks were. They are incentivized to kick the can down the road and hope. But hope is not an investment strategy.
Recovery rates next time around won’t be so good—covenant-lite loans have 50 percent lower recovery rates than more conventional loans—and lenders will be getting the keys to businesses after the companies have lost much of their cash flow and value. In traditional bank deals monitored by a workout group, reporting was critical. In the current lending environment, many protections, including reporting requirements, have been stripped away, making a workout even more challenging. Furthermore, these new firms have no experience in even how to perform due diligence for these deals, much less how to operate these businesses.
What should investors expect, and where should they put their money to protect it against all of these concerns? An investor should expect returns to mildly compress in the next 12 months but should demand that credit protection not be watered down. Sacrificing price is one thing as a creditor, but sacrificing downside protection is not something one should consider.
In the end it comes down to individuals’ risk thresholds and what they are looking to accomplish. Do they believe statistics from the Great Recession and figure they could withstand even double that level of losses? Logic would dictate that if capital needs to be deployed that a barbell approach probably makes the most sense, where some capital is invested in larger players that have several hundred credits to diversify the aforementioned risk and other capital is placed with opportunistic credit funds that are unique in their approach.
Investors may ask, “Why not invest in a distressed vehicle and be ready to pounce when the market dips?” The problem with that approach is that no one wants to invest in distressed opportunities when the economy is clicking and none can foresee the catalyst for the next recession. Moreover, LPs don’t want to pay fees on committed capital—only on invested capital. Timing the market is impossible. Where lenders do not want to be right now is in “cookie-cutter” lending exclusively to private-equity-owned companies. As mentioned earlier, this is a crowded market, full of competition. It is challenging to truly build great risk-adjusted returns under this model, given where the market is today.
Administrations in Washington, D.C., come and go, and legislation from time to time impacts the finance markets. There is no greater example of that than the Dodd-Frank Act/Volcker Rule, which brought historic change to the banking system (driven mostly by market forces) that decimated large and small bank lending. While some expect that larger banks will slowly creep back into the market as legislation loosens over time, the middle market lending environment is here to stay.
Credit investing is not particularly difficult, as long as investors keep some simple principles in mind. First, credit typically shares in one fluctuating area of the investment—downside. Therefore, investors should insist on vital creditor protections, such as covenants and limitations on the borrower, that are key to controlling the investment post-close. They should pick good quality companies that have a reason to exist and that also have niches. Finally, investors should remain patient and not feel compelled to deploy capital quickly or to become asset-gathering machines. It’s a simple blueprint for success through cycles, but one currently ignored by almost everyone in the industry.
It’s difficult to predict when the confluence of currently favorable conditions will lead to a perfect storm that brings about a cyclical downturn in the credit markets. Although it is currently a good time to be a borrower or intermediary, it will be an even better time to be restructuring advisors and opportunistic lenders after the cycle turns. Steadfastly adhering to sound investing principles and understanding that not everything lasts forever are the keys to being a successful investor through both calm and turbulent markets.