6 minute read
lockdown FRP Advisory: Weighing
Weighing up opportunity
How are direct lenders responding to the pandemic?
Tom Cox Partner FRP Advisory
Ian Corfield Partner FRP Advisory
This year has already been a significant year for the direct lending market, with historic portfolio selection by all funds tested in full. The ongoing crisis has enveloped global economies, bringing disruption and uncertainty, and the behaviour of the private credit market will continue to be stress-tested in the face of significant borrower performance volatility – even if it is not of their own making.
Despite the private credit market having operated for over a decade, many borrowers and sponsors have continually questioned how direct lenders would behave in a recession. While the crisis has already seen major banks facing extraordinary levels of funding requests linked to wider government support, it could now represent a major opportunity for fund capital deployment as a lifeblood to many companies – particularly with initiatives like the Coronavirus Business Interruption Loan Scheme drawing to a close.
Scheme closures
However, direct lenders have not – and will not continue to be – immune to pressures that have enveloped the banks, as the size of portfolios has grown rapidly in recent years. Some of the largest funds operate portfolios of more than 100 assets.
The reality is that everyone will suffer to some degree, such is the portfolio effect. The limited bandwidth of many direct lending teams (and understandable lack of genuine restructuring capabilities) will therefore continue to be tested in full.
On the front foot
As lenders continue to navigate a challenging environment, we expect them to act proactively and rationally, such is the structure of their capital and the incentive mechanisms of their managers.
At the onset of the pandemic, we saw many lenders react swiftly to triage their portfolios and focus on fighting the fires burning brightest. The absence of large committees or processes for decision making will continue to prove beneficial as direct dialogue with sponsors and management teams can take place on a near daily basis and stakeholders quickly react to any new developments.
Our discussions with the wider community suggest most, if not all, funds have remained open for business albeit with a caveat: the portfolio has come first, and they have prioritised supporting existing borrowers where possible. Regular detailed dialogue with LPs has increased considerably and we are now seeing lenders demonstrate their credibility as a true funding partner to more complex or stressed businesses.
Whilst private credit portfolios have grown considerably over recent years, they remain relatively small in comparison to the major banks and they will continue to react in a nimble fashion as the pandemic, and our exit from it, continues to present funding challenges. We predict that direct lenders will support borrowers where requests for funding are credible and defensive, even if it potentially increases optical leverage for a period.
Borrowers shouldn’t expect lenders to simply offer an easy ride. Fund structures cannot truly afford significant write offs, despite offering shorter credit decision-making lines to plot a route through the current crisis.
While covenants became somewhat irrelevant at the start of the crisis, we anticipate the development of a suitable suite of lenders protections to come back into focus once the operational landscape has become clearer. In the early stages of the pandemic, lenders offered short-term cash flow solutions to help with stretched liquidity through forbearance on cash sweep mechanics, extension of maturities and conversion of cash margins to PIK, and while this will likely continue for sustainable businesses encountering difficulty in the next few months, rather than crystalise a loss, we expect attitudes to evolve next year.
As the genuine impact of the crisis begins to unfold in 2021, we expect direct lenders to work closely with borrowers to establish revised covenants and information packages that, while presenting some operational flexibility, ensure warning flags emerge early and corrective action can be taken without an uncontrolled crisis unfolding.
Direct lenders are likely to be pragmatic about other liquidity injection solutions, but we would not expect a blanket opportunity for super senior rescue finance that subordinates the senior secured lender to flood into deals unless alternative solutions have been exhausted. Ultimately, it will be important for primary secured lenders to stay in control of their destinies as we look ahead to a more stable business landscape.
Where businesses enter distress in the months ahead, lenders will likely continue to first look proactively to sponsors and other equity holders to support assets. To date, the most collaborative approaches from equity have secured the most favourable or cooperative response from lenders. We expect that to continue as both components of the capital stack seek to protect their interests.
If equity support is not available or forthcoming, lenders won’t be afraid to seek risk-weighted returns or perhaps even go as far as ‘taking the keys’. Ultimately, the fund must protect the position of its LPs and equity recoveries may be the only option if a borrower would otherwise simply end up in insolvency.
Hope for new deals?
Several of the funds that we have spoken to believe a market correction was ultimately due. The biggest issue now will be pricing risk in a market that is still uncertain. For relative value funds, this will simply mean upward re-pricing of paper given temporary dislocation in the liquid markets witnessed at the start of the crisis.
We envisage:
• Leverage will continue to contract across the wider market as lenders are forced to take a more cautious approach, with the core focus on structuring EBITDA, outturn forecasts and longer-term supply chain risk in new deals. This in turn creates opportunityforfundswithdifferentriskappetites,horizons, andflexibilityondebtstructures/products.
By contrast the strongest credits may still attract eye-watering terms as a lack of supply in the most defensive sectors (pharmaceuticals, healthcare, technology and e-based logistics) potentially attracts a feeding frenzy with continuing deployment still necessary amongst the larger funds.
Therecontinuestobesignificantdrypowderacrossthedirect lender market in the form of committed long-term capital that
lenders are incentivised to deploy. We are aware that some are continuing unabated, but we expect others to remain cautious incommittingsignificantnewcapitaluntilweseefurther market stability and/or borrowers are restructured. Indeed, new capital may be conditional upon such restructurings.
New money deals will continue to emerge as new winners come out of the crisis, but portfolio selection will be more important than ever.
• In the short-term, newer smaller cap funds with limited portfolios may see genuine opportunity with reduced competition from the banking market and more bandwidth to assess new money opportunities. Similarly, lenders may retrench somewhat to focus on more asset-backed situations.
This may see a growth in more hybrid structures where the underlyingcollateralandcashflowarecombinedtosolvethe financingask.
• In the mid-term, we are seeing some lenders re-purpose new fund raises into credit opportunity or corporate dislocation capital as there will inevitably be an extended hiatus in vanilla M&Aopportunities.Thoselenderswithmoreflexiblecapital pools may be better placed in the near-term to deploy into more opportunisticorrescuefinancingsituations.
The current crisis will be an existential threat for many and there will no doubt be some significant fund and borrower casualties as a result. The next few months will continue to be important in this journey. “ To date, the most collaborative approaches from equity have secured the most favourable or co-operative response from lenders
