What do you think are the factors driving the incredible growth in distressed debt and special opportunity funds?
First, there’s the legacy effects of a long-term zero interest rate environment, and the proliferation of dividend distributions from a lot of LBOs, especially from the sponsor finance community, or private credit funds. They were done when rates were low – one floor or two for reference rates – and now it’s ticking up to the five range.
And with these legacy spreads and the current reference rates, some of these companies can’t afford that debt service as part of their operating model. That’s starting to trigger a lot of the EBITDA covenants within their underlying credit and lending agreements.
So we’ve seen a lot of our traditional private credit lenders and opportunistic managers launching special situations and credit opportunity funds, where they can step in, restructure the debt, and maybe put it on non-accrual or non-cash pay for a period of time to work these deals out. There was a bump in these funds being formed at the beginning of covid, with the assumption the pandemic would create a boom in distressed situations for the then pending economic distress.
However, due to all the government stimulus, that boom was delayed. But with the prolonged increase in rates, even with the continued economic performance, a lot of these managers are expecting that boom to commence. There are also situations like the collapse of Silicon Valley Bank that suggests there will be interesting portfolios coming to market, priced to be offloaded quickly and able to be worked out at significant returns to investors.
Do you think that same environment is fueling a rise in asset-based lending funds?
Traditional asset-based lending is typically lending where there’s a lag time between when corporate borrowers need to finance their commercial operations and bridge the period of time that their customers are paying them for the product that’s been delivered.
Up until recently, that’s been the world of a money center bank, or a super-regional money center bank that have these facilities where they will make those loans, monitor those loans and pledged collateral, and keep that relationship with a borrower. But given the ultra-sensitivity of those super-regional bank market events, those are really good loans to shed because they have high market value, without the bank to reserve against them.
So we’ve seen a number of those portfolios come to market where it’s private capital that will take on those ABL facilities on behalf of the borrowers at a pretty good rate from the original bank lender.
And then there’s the role of the traditional investment bank on providing portfolio leverage, which we now see large insurers and actual funds coming in to replace them, despite all the compliance issues and strict rules around what’s applicable, what’s admissible, and substitution rights if a particular asset goes wrong. This is now becoming the realm of large insurers, since they have a more permanent capital base, one that isn’t based on deposits.
We’ve had a few clients entering into lending or refinancing arrangements, and they really liked the term loan and the borrower. The borrower then brings up the fact that they also have this ABL and would like to have the same provider for both.
So the manager decided to meet that market need, and as a result, we ended up exploring what we could do to service them, and licensed a product dedicated to the ABL space that provides transparency to the lender, the borrower and us though the operating infrastructure.
For managers looking to launch their first credit fund to take advantage of this environment, how should they think about the operational infrastructure to administer it?
When I speak with PE managers that are used to underwriting and investing in a portfolio company and valuing their portfolio once every quarter, they’re in for a very different level of activity in the credit space. The same underwriting process and the ongoing valuations occur, but additionally the bank debt pays at a minimum quarterly, and the rate resets typically quarterly. There are amortisation payments. Loans are typically originating below par. So they’ve got non-cash income that they need to recognise.
These deals get amended constantly, so there could be different compliance rules under the credit agreements. Furthermore, the maturities get extended, the size of the deal could move up and down, and all this requires a great deal of monitoring of the underlying borrower. And they need a system that will address and support all those things.
They have to decide who will be the administrative agent on the credit, whether it’s done internally, or outsourced completely.
Then there’s SEC oversight around the custody of investor assets. How are they going to build an infrastructure where they’re not co-mingling investor monies across multiple funds or different borrowers and everything else required to withstand the scrutiny of the SEC? And that’s just on the legal and operational side of things.
As a result, our clients invest a lot of resources on attorneys, compliance experts and our services because we have the appropriate systems for the agent components, the loan administration, which is tracking and ticking and tying all the cashflows, positions, rate resets, amortisation schedules, and then ultimately the fund accounting and investor reporting. Because a direct result of this growth in private credit is there is a dearth of people that know how to do credit accounting because it is very different than PE, or fund-of-funds accounting.
This ends up producing a massive amount of data to monitor and manage. The front office wants credit monitoring. The middle office needs to monitor the compliance with the credit agreements. And then the back office needs the data to produce the reports and everything else. There are big ticket systems available that cost millions to implement or off-the-shelf systems that support various functions for credit managers.
There are much lower cost solutions for data warehouses where they can build report writing software on top of the warehouse – these become a kind of integral hub for the spokes that go out to address reporting requirements. And then there are other inexpensive add-ons that can offer portfolio view technology as well.
Most clients want that data in-house, but it’s a daunting task to build internally. This is why we’re confident that outsourcing will continue to offer a compelling value proposition for the GPs looking to make the most of this particular moment in the credit markets.
This article was originally published in PDI's US Report.