Direct lenders: weathering the storm

2020 looks set to be a watershed moment for the direct lending market when historic portfolio selection by all funds will be tested in full. The current crisis enveloping global economies is likely to be sharp and somewhat chaotic, and the behaviour of the private credit market will finally be stress-tested in the face of significant borrower performance volatility – even if it is merely short-term and 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 – well, we’re about to find out.

With the major banks facing extraordinary levels of funding requests linked to wider government support, the crisis could in fact represent a major opportunity for fund capital deployment as a lifeblood to many companies – particularly the vast swathes of mid-market borrowers operating between the CBIL and Corporate Financing Facility schemes.

However, direct lenders will not be immune to the pressures enveloping 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 be tested in full.

On the front foot

We expect direct lenders to act proactively and rationally, such is the structure of their capital and the incentive mechanisms of their managers. As such, we have seen many lenders already react swiftly to triage their portfolios and focus on fighting the fires burning brightest. The absence of large committees/processes for decision making should prove beneficial as direct dialogue with sponsors and management teams can take place on a near daily basis and pivot rapidly.

Our discussions with the wider community suggest most, if not all, funds remain open for business albeit with a caveat: the portfolio will come first, and they will prioritise supporting existing borrowers where possible.

That being said, 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.

In the short-term, covenants are likely to become somewhat irrelevant (especially given the joint statement released by the FCA, PRA and Financial Reporting Council) and lenders will likely offer 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.

Direct lenders are also 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 exit this crisis.

In most instances, lenders will first look proactively to sponsors and other equity holders to support assets.

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. For relative value funds, this will simply mean upward re-pricing of paper given the current dislocation in the liquid markets.

We envisage:

• Leverage will contract 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.
• Most of the market will be inactive in new money deployment for at least one to three months given the uncertain length of market dislocation and global lockdowns. As such, this re-pricing discussion may become irrelevant until the liquid market settles down.
• There will continue to be significant dry powder across the direct lender market in the form of committed long-term capital that lenders are incentivised to deploy even though new fund-raising activities will generally be on hold. We are aware that some are continuing unabated, but we expect investors to remain cautious in committing significant new capital until a level of market stability has returned.
• In the short-term, newer smaller cap funds with limited portfolios may see genuine opportunity with reduced competition in the 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 underlying collateral and cash flow are combined to solve the financing ask.
• In the mid-term, we may see some lenders re-purpose new fund raises into credit opportunity capital as there will inevitably be an extended hiatus in vanilla M&A opportunities. Those lenders with more flexible capital pools may be better placed in the near-term to deploy into more opportunistic or rescue financing situations.

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 three to six months will be vital in navigating this journey. FRP is well placed to support direct lenders, sponsors and shareholders on that journey, combining Debt Advisory and Restructuring skillsets to assess options and manage stakeholder negotiations from all sides of the table.