Direct lenders take the strain

Q3 2020

Feature

Karis Hustad

Reporter

Debtwire

GPs share their perspectives on direct lending’s performance through the pandemic and where the industry could be headed

Since March, direct lending has been in the throes of its first real test: how would the asset class perform when faced with a crisis, one perhaps worse than even the 2008 recession that led to its ascent?

After six months of pandemic-induced lockdowns, with M&A way down and deployment difficult, direct lenders have largely dealt with their portfolio issues with better-than-expected performance for companies. Now, with some restrictions having been lifted and certain markets reopening, lenders are finally getting the chance to examine new deals.

But the trials and tribulations are far from over.

A resurgence in COVID-19 infections has given rise to another series of wide-scale lockdowns and pronounced economic disruption. However, direct lenders are looking to take advantage of any time available to them, running hard at the credits that are likely to endure the coming downturn. While there are more opportunities now than there have been in recent months – and, with banks pulling back in certain markets, more space opening up for private debt – the increased competition is driving down prices with terms back to where they were pre-COVID-19.

“People who missed out under lockdown are under pressure to deploy, and only a few good cases are out there,” said a direct lender.

M&A makes a return

Funds have already handed out the initial covenant waivers and holidays, and with six months of trading under the worst conditions already past, lenders have been able to take stock. This has freed up time to chase returning M&A activity, at a time when direct lenders still have plenty of money on hand – and an incentive to put it to work, with management fees being mostly paid on deployed capital.

“This is the busiest we have ever been,” said a second direct lender. “We may end up having our best-ever quarter.”

After a quiet start to Q3, the auction pipeline has picked up significantly, with vendors keen to hit the market with assets that were ready for sale pre-lockdown. Supply is also coming from companies looking to refinance debt, with an eye to a sale if conditions improve in 2021. Over-the-counter and bilateral deals, particularly those between sponsors and funds with pre-existing relationships, have been another key source of dealmaking for direct lenders.

According to Nicolas Cofflard, managing director of debt and restructuring advisory practice at Paris-based DC Advisory, there are two types of credits in particular returning to the market. The first is ‘super credits’, businesses that have performed in line with expectations or better than usual throughout the COVID-19 lockdown. The other variety is ‘resilient credits’, businesses in which the LTM EBITDA is down by around 10%, but where there are strong prospects of a return to normality or better in 2021.

“What we are seeing now is the winning M&A sectors in the post-lockdown world: healthcare, tech, infrastructure,” said Cofflard.

In some markets, this presents a unique opportunity for direct lenders. As banks continue to retrench, the availability of private debt capital can fill in the funding gaps.

“Direct lenders have the funds, which is a clear competitive advantage, whereas for banks the appetite for underwriting has reduced, but not disappeared,” said Cofflard. “Where you’d need two banks before, you’d need three or four now.”

Competition grows fiercer

While there is a crush of new processes, the volume is still lower than in previous years. And with largely recession-proof business returning, and an all-but-certain prolonged recession to come, everyone is keen to invest in these assets and are willing to push hard to win mandates.

“There are still the same number of direct lenders fighting for much fewer opportunities,” said Cofflard. “There is no point in taking higher risk, so they will have to live with tight margins and loose documentation.”

Pricing and leverage has remained at pre-COVID-19 levels on the ‘super credits’, while terms for less desirable assets have stayed more lender-friendly, settling at 50-100bps higher, with leverage typically down a turn from pre-COVID-19 levels. Though even that has started to erode in recent weeks as lenders scramble for deals, said one lawyer.

“The floor on pricing has moved: what was E+ 550-575bps is now E+ 650bps on [less COVID-19-proof] deals, which is good,” said another direct lender. “But you’re still seeing crazy terms and crazy leverage on anything decent.”

After a quiet start to Q3, the auction pipeline has picked up significantly, with vendors keen to hit the market with assets that were ready for sale pre-lockdown.

Certain terms that will be especially pertinent if a harsh economic downturn stretches through 2021 or beyond are a sticking point. EBITDA adjustments are being scrutinised, with lenders looking carefully at whether a sales slump is pandemic-related or symptomatic of a deeper issue.

“If you’re a direct-lender fund manager, the last thing you want to experience is to explain to your LPs that you took a hit on a business that experienced difficulties during the lockdown and COVID periods, when anyone could have predicted the long-term impact on the business,” said Cofflard. “No one will look at those credits, unless you get a premium.”

But with six months of patchy dealmaking keeping lenders from putting money to work and collecting management fees, there’s a sense that if there was ever a time to deploy, it is now, before things have a chance to, potentially, get much worse again. “Yes, everyone has a few problems and are still deploying,” said the second direct lender. “Until someone tells you to stop, you keep deploying.”

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