Private Credit

Transcript

In the public markets, larger companies can issue bonds at fixed coupon interest rates. These fixed-income securities have interest rate risk and price volatility. This risk can be measured by duration, with greater price volatility seen in debt issues with longer maturities. For example, a ten-year bond may have a duration of seven years, leading to a 7% decline in the bond price for each 1% increase in interest rates. Debt issued in the public markets can be traded daily and can have a high degree of liquidity. Bonds are typically unsecured debt issues that are issued with minimal covenant protections, limiting the degree of control of the lender. The risk of unsecured debt is related to the credit rating of the borrower, which improves when the debt is a smaller portion of the company’s capital structure and the interest burden is small relative to the cash flows of the company. Agencies publish credit ratings for borrowers in the bond markets, with companies deemed to be investment grade borrowing at lower credit spreads and companies determined to have ratings below investment grade borrowing at higher credit spreads. Publicly-traded corporate bonds are typically unsecured debt, which sit lower in the capital structure and can experience greater losses during bankruptcy.

In contrast, private credit loans are underwritten by non-bank lenders for companies that are often too small to be able to borrow from banks or the public bond market. Private credit loans have a low degree of liquidity and are typically held to maturity by the lender. While borrowers tend to have the upper hand in the public bond market, lenders have more control over borrowers in the private credit market. Private credit loans often come with stronger covenant protection, where borrowers often pledge collateral with loan-to-value ratios of 40% to 70%. This secured debt sits higher in the capital structure than unsecured borrowings in the bond market, with secured private credit loans experiencing a higher recovery rate during bankruptcy, which may come from the lender taking control of the assets pledged by the borrower. Private credit loans typically have floating interest rates, where the borrowers pay a fixed credit spread over a floating rate base. For example, a private credit loan may charge a credit spread of 600 basis points over the secured overnight financing rate (SOFR). When SOFR is 3%, the borrower’s interest rate is 9%, which can rise to 11% when SOFR rates increase to 5%. Because the interest rates are reset each quarter or semi-annual period, floating-rate loans have much lower interest rate risk or duration than fixed-rate bonds.

Investors can access private credit loans through drawdown funds, similar to private equity, or evergreen interval funds. Private credit drawdown funds may have a stated life of five to seven years, require investors to be qualified purchasers, and call and return capital on an irregular schedule. Evergreen interval funds have been structured for the private wealth market, with a perpetual fund life, the ability for capital to be fully invested in any given month, and can be purchased by accredited investors. Some funds may even allow retail investors to invest with very low minimum required investments. Interval funds are named due to their structure that allows investors to access liquidity at regular redemption intervals. A typical schedule is quarterly redemptions in the amount of 5% of the fund’s net asset value (NAV). In any calendar quarter when less than 5% of the fund’s assets are submitted for redemption, exiting investors will receive their full withdrawal request. When 10% of the fund’s assets are submitted for redemption in a single calendar quarter, investors are likely to receive half of their requested withdrawal amount and a new withdrawal queue will form in the next quarterly redemption period. Interval funds may distribute a high income yield, but the evergreen nature of the fund requires the proceeds of loan maturities to be recycled into new loans.

There are a variety of strategies in private credit funds. Some funds may be focused on one or two strategies, while others may be diversified across several strategies, including direct lending, mezzanine, distressed, specialty finance, credit special situations, bridge financing, and asset-backed lending.

In the direct lending strategy, private credit funds underwrite bespoke loans, typically to US and European corporations. When investing in a direct lending fund or any other private credit strategy, investors are encouraged to perform due diligence on the fund’s investment strategy. The fund will typically have lower risk when secured loans are made with strong covenants, full documentation, and low loan-to-value ratios. Funds may earn higher yields on unsecured loans, but are taking greater risks to do so. Many borrowers access the private credit market because their EBITDA or borrowing size requirements are much smaller than that required in the leveraged loan or high-yield bond markets. Larger borrowers may access the private credit market if they need to close a financing deal quickly or on terms typically not offered in the public markets.
Because smaller borrowers may find it difficult to access credit in the public markets, they often experience a higher cost of borrowing and stricter covenants. Private credit lenders with proprietary deal flow who originate their own loans may offer greater borrower diversification than funds that purchase loans in the syndicated market that are widely held in other funds. While most borrowers in the private credit market have not been issued a credit rating by an agency, secured loans with low leverage and strong covenants have historically experienced low default rates and loan losses.

Mezzanine loans are a hybrid between debt and equity securities that are often used to support leveraged buyouts (LBOs). Private equity funds often use 50% equity and 50% debt to purchase a portfolio company in an LBO. If the company is purchased at 12 times EBITDA, the debt load is 6 times EBITDA, far beyond the 3 times EBITDA limit typically borrowed by investment-grade companies. Because of the high degree of leverage on mezzanine loans, lenders may receive a floating-rate coupon of SOFR+500 basis points or higher in addition to equity warrants. Similar to call options, equity warrants provide upside returns when the underlying equity value increases. Some lenders like sponsored loans, as the private equity general partner has already completed substantial due diligence on the company. Because mezzanine loans are higher in the capital structure than equity, private equity GPs may lose the value of their equity investment in the company purchased in an LBO when the mezzanine loan goes into default. The private equity sponsor may be willing to support distressed mezzanine loans in order to protect their equity investments. Sponsored loans may have higher leverage and lower credit spreads than non-sponsored loans. Some mezzanine loans have a PIK toggle feature, where the borrower has the option to pay interest in cash or more loan principal where PIK is paid-in-kind.

Historically, mezzanine loans have offered higher returns than direct lending, distressed investments, and senior debt, while earning lower returns than public or private equity investments. The goal of the PE GP is to exit their investment in the company purchased in the LBO, ideally after substantially reducing the company’s debt load over a holding period of five or so years. Mezzanine debt is repaid with proceeds from an IPO or sale to a merger partner.

Specialty finance strategies may be relatively uncorrelated with broad debt and equity markets. Specialty lenders extend credit backed by royalties, litigation finance, life insurance, receivables, public and private securities, and consumer loans.

Some private credit strategies invest in stressed or distressed credits. Stressed credits are performing loans. While the borrower may be currently paying interest as scheduled, the probability of default is high, as the debt load and interest payments are significant relative to the company’s assets and cash flows. Defaults are most likely when the maturing debt cannot be refinanced or paid in full. It is less likely for defaults to occur when interest payments are due. It is important to understand the maturity and liquidity structure of the borrower. Smart lenders will make loans that are likely to be paid in full before the borrower’s liquidity dries up and maturity payments cannot be made. Some hedge fund investors may implement a capital structure arbitrage strategy with long positions in shorter maturity loans that are more likely to be repaid and short positions in longer maturity loans that are less likely to be repaid.

Distressed loans are non-performing loans that have already defaulted. Because distressed loans are unlikely to be paying the full interest when it is due, investors in distressed funds are unlikely to earn substantial current income. Because distressed investors often buy loans after they have defaulted, they are more focused on capital appreciation than current income. The goal is to buy the debt at a discount to par and receive a higher value in restructured securities at the end of the bankruptcy or workout process. That is, investors can profit by buying debt at one-third of face value and receiving two-thirds of face value at the conclusion of the bankruptcy litigation. Distressed investors may be able to purchase defaulted debt at a discount to its recovery value because some investors, such as pensions or insurance companies, may be legally required to sell some or all of their distressed debt holdings, regardless of the price, to satisfy regulators.
It is important to understand the priority of claims in a bankruptcy process. Senior and secured debt have the highest priority of claims; subordinated, unsecured, and mezzanine debt have the middle priority of claims; while equity has the lowest priority of claims. In many reorganization bankruptcy processes, senior debt holders receive debt, often at a lower coupon or face value than their pre-bankruptcy position, such as two-thirds of face value. In most bankruptcy processes, the equity holders lose their entire investment. Many distressed investors want to hold the fulcrum security, often a subordinated debt issue that is repaid with newly-issued equity in the restructured firm. While the initial recovery value might be only one-third of the face value of the subordinated debt, the ultimate recovery may be higher than face value if the newly issued equity posts strong performance.

Some distressed investors, especially hedge funds, buy and sell debt issues to earn a return of cash or restructured debt. Other distressed investors seek to take control of the company’s assets or equity by owning debt issues, as the initial shareholders typically lose their equity stake during the bankruptcy process. Distressed investors seeking control are searching for good companies with a bad capital structure. If a debt-for-equity swap can relieve the company’s financial distress, the company may be able to survive as a going concern. If the underlying corporation is profitable or the assets are valuable without leverage, there can be opportunities to profit by deleveraging the capital structure through the bankruptcy or workout process.