Private-Debt Funds Withstand Covid-19, but Bigger Test Comes Next Year

Private-Debt Funds Withstand Covid-19, but Bigger Test Comes Next Year (Photo: iStock)
Private-Debt Funds Withstand Covid-19, but Bigger Test Comes Next Year (Photo: iStock)

Summary

  • Funds that lend to smaller companies such as dentist offices and software makers have grown into a major part of the financial infrastructure

The riskiest corners of corporate-debt markets have escaped widespread damage from the Covid-19 economic crunch. Some fund managers think a reckoning may still be in store in the rapidly growing universe of private lending to smaller companies.

Private debt has grown to become a major part of the financial infrastructure in the U.S. and Europe since the 2008 financial crisis, as banks reduced lending to smaller companies. It is different from other forms of lending because it is done directly from a specialist fund manager to all sorts of companies—dentists, restaurants, insurance brokers and software makers, among others—without going through either a bank or bond markets.

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Many companies have faced hard times during lockdowns, but the unprecedented support from governments and central banks across economies in the U.S. and Europe has limited the damage.

“Next year when the [government] funding stops and companies have to pay this money back, that’s when the problems will come," said Ganesh Rajendra, managing partner at Integer Advisers, a London-based consulting firm.

Assets under management at private-debt funds have rocketed from less than $200 billion globally in 2007 to $850 billion by the end of March this year, according to the latest data available from Preqin, a research firm. Fundraising slowed this year, but funds still have almost $300 billion of uninvested capital.

There have been failures in the private-lending market, such as the department store chain Debenhams in the U.K., a midsize business that ended up being owned by its private lenders before it was put into liquidation.

The U.S. private-credit default rate hit 8.1% in the second quarter, up from nearly 6% in the first quarter, according to an index created by U.S. law firm Proskauer Rose LLP. In the third quarter, the rate has dropped back to just 4.2%.

For comparison, back in May when the Covid-19 crisis was in its first wave, ratings agency Moody’s forecast default rates of at least 11% and up to 21% among junk-rated borrowers globally in 2020. Those forecasts have been cut since then.

“People tend to predict things early: Just because defaults haven’t happened yet, doesn’t mean they won’t." said Andrew McCullagh, managing director at Hayfin Capital Management, one of Europe’s biggest private lenders with about $20 billion in assets.

“When you get to June next year and a company is coming back for that next round [of extra funding or covenant relief], by then you will have 15 months of poor performance and you’ll have to ask if it’s a business that’s going to come back," he said.

It is hard to assess how well private-debt funds are doing because like private-equity funds, they lock up investor money and their real performance may not be apparent for five years or more.

Many funds don’t have to adjust the valuation of their loan books aggressively as long as the debt is still being serviced. That differs from banks, which have to take account of economic conditions and the probability that companies will develop repayment problems.

Chris Skinner, head of U.K. debt and capital advisory at Deloitte, said this year has made it very hard for lenders to judge how borrowers will perform over the longer term because the Covid-19 crisis continues to bring so much uncertainty to economies. That has made them reluctant to cut the value of loans if they don’t have to. “People have pleaded the fifth on valuations," he said.

Private lenders have given borrowers more leeway this year so that they don’t default. One window into what has been going on is through business-development companies, publicly listed versions of private lenders.

A business-development company run by Ares Management Corp., one of the world’s biggest private-credit managers with more than $130 billion in assets across its debt businesses, told investors in August that it had amended covenants on 40 different loans in the second quarter alone. Other BDCs, including those managed by Apollo Global Management Inc. and BlackRock Inc. reported amendments from a similar proportion of their borrowers.

BDCs suffered share-price falls of more than 50% in March and April, but have since recovered much of that ground.

Blair Jacobson, co-head of European credit for Ares, said many of its coronavirus-affected borrowers in its private-credit funds were resilient businesses such as dentists or veterinary practices. “The rebound was strong: A lot of those companies that needed deferrals have already made good on those," he said.

Another factor keeping borrowers solvent is many of them are backed by private-equity funds, which are piling on less debt than in the past. There is more equity in most businesses and loans are around 50% of the enterprise value, Mr. Jacobson said, compared with 70% to 80% before the last financial crisis.

“Private-equity owners have much more to fight for and a lot more has to go wrong before lenders suffer losses," he said.

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