March 11, 2020 / 2:56 PM / a month ago

Coronavirus puts private credit to the test

NEW YORK, March 11 (LPC) - Private credit funds face a challenging fundraising environment, as investors grapple with a potential decline in portfolio values while the coronavirus outbreak tests the solidness of a market that has yet to experience a significant shakeup.

Also known as non-bank lending, the private credit asset class has erupted since the financial crisis, boosted by robust investor demand, which seemed almost unabated as banks retreated from issuing loans to smaller borrowers.

But uncertainty regarding the adverse effects of a potential global pandemic on the US economy has made investors wary. Deals are on pause, investor meetings are being canceled, and fundraising schedules postponed as market participants struggle with the yet-to-be-seen fallout.

REBALANCING ACT

Private credit investors, such as pension funds and insurance companies, have asset allocation policies that specify what percentage of their portfolio is public stocks, private credit and other investment strategies.

As equity markets decline, an investor’s overall portfolio may need to rebalance to maintain allocation targets. The dollar value of private credit allocations would need to be adjusted as a consequence of reduced portfolio value.

“A significant correction in equities will leave asset allocation in severe imbalance, and rebalancing is required. The consequence of which means less short-term investments in (the) private market,” said Jess Larsen, partner and chief executive officer of Americas at fundraising advisory firm FIRSTavenue Partners.

Facing heightened market volatility, private credit investors may also take a more conservative approach. Rather than adding new private credit managers to their portfolio, investors would likely focus on renewing commitments to existing credit managers, Larsen explained.

“Signed commitments will be upheld,” he said. “However, new investments may end up being on hold until the balance is restored within their (asset allocation).”

But if the market panic created by the virus is only short-lived, a re-evaluation of the investors’ asset allocation may not be necessary, Larsen said, and “normal business” could resume in a few months.

Travel restrictions could further impact fundraising and the search for new clients.

One firm seeking capital for a successor fund postponed fundraising trips to Asia, adopting a discretionary travel policy similar to other firms across finance.

“If it’s a fund where you’re going to a lot of existing investors, you’re trying to make use of video conference calls,” the source said. Winning new investors can be more difficult without face-to-face meetings, the direct lender explained.

RISKY DOCUMENTS

An unforeseen result of the health emergency could further erode lender protections in favor of the borrower.

A recent middle market leveraged buyout (LBO) included a provision enabling a borrower to add-back losses related to the impact of the coronavirus outbreak.

The development could give private equity firms even more flexibility to inflate earnings before interest, tax, depreciation and amortization (Ebitda) projections, which affects everything from debt taken on by the company to business decisions the management can make.

Under the “extraordinary, unusual, or non-recurring charges” clause, the borrower may add-back losses attributed to several events, including natural disasters, which – while not mentioning it directly – would likely apply to coronavirus.

A report from research firm Covenant Review has warned that such a provision, while likely driven by coronavirus fears, allows the borrower to make restricted payments – which can include dividend distributions – and incur additional debt without lender input.

“It opens up the document to even more flexibility. And (private equity sponsors) can use that add-back for lost earnings in the future for other non-recurring events. But it’s also speculative – how do you determine the lost earnings from the coronavirus outbreak?” said Ian Walker, an analyst at Covenant Review.

OPPORTUNITY

Challenges create opportunities, and private credit lenders could see some upside from the market volatility derived from the virus.

A long-standing complaint by private credit managers and private equity firms that invest in the middle market is the high asset valuations of target companies, fueled by sponsors’ record amounts of dry powder.

As valuations have increased, so has leverage. Average debt-to-Ebitda levels for middle market LBOs was 6.53 times in the first quarter of 2020, up from 6.25 times in the previous quarter, according to Refinitiv LPC data.

But a long-term sell-off in the stock market may reverse the trend of high asset valuations for companies, especially for private equity firms hunting for opportunities in the public markets.

“Private markets ultimately take their cues from the public, liquid markets. Public equity values go down, so will private equity values over time. Sometimes it takes six to nine months for the effect to happen. At this point, it’s too early to make (a) judgment,” said Art Penn, managing partner at asset manager PennantPark. (Reporting by Andrew Hedlund and David Brooke; Editing by Michelle Sierra and Kristen Haunss)

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