Private debt players open for business, but only on the right terms

Private debt managers seized the opportunity to win market share in 2022 as leveraged loan and high yield bond activity slowed—moving into 2023, private debt players remain open for business, but mainly on their terms

Private debt enjoyed a breakout year in 2022, as managers in the space took on larger transactions and continued to grow assets under management (AUM) despite macroeconomic headwinds.

AUM in the private debt space reached a high-water mark of US$1.4 trillion in 2022, according to Preqin, up from US$250 million in 2010. With more capital at their disposal, private debt players were ideally positioned to fill the gap left by high yield bond and leveraged loan markets, where debt issuance ground to a halt as rising interest rates and inflation took hold.

This opened up opportunities for private debt funds to finance large credits that usually would have been financed by syndicated bank loan and bond capital. Blackstone’s private debt business, among other lenders, for example, provided a US$5 billion financing package for the leveraged buyout of software company Zendesk, while Ares and Blackstone, among other lenders, participated in a US$4.5 billion loan to fund Hellman & Friedman’s buyout of Information Resources.

Private debt players have also become increasingly influential in syndicated loan markets, buying up parcels of debt from underwriting banks that have been unable to fully assign loans to traditional institutional investors.

According to Bloomberg, banks were sitting on approximately US$40 billion in buyout debt that was stuck in syndication at the end of last year. Eager to unwind these positions and clear their books, banks have been willing to sell these loans at a discount, with private debt players ready to step up as buyers. Pimco, the California-based debt fund manager, for example, bought more than €1 billion in loans from banks that underwrote the buyout of payments business Worldline, and €500 million of the debt that was financing the buyout of UK supermarket Morrisons.

Private debt club deals evolve and expand

Another feature of private debt dealmaking in the past 12 to 18 months has been the rise of large private debt club deals where lenders combine resources to either fund jumbo credits or manage deal concentration risk.

Private equity sponsors have also been in favor of club deals, not only as a way to secure large amounts of debt for the transactions, but also as a tool to ensure that no single creditor holds a controlling position in the portfolio capital structures.

As private debt players generally have similar risk appetites and approaches to underwriting, forming clubs to fund transactions has been relatively straightforward, facilitating smooth and reliable deal execution in a choppy market.

There are, however, some nuances when pulling together clubs that have influenced documentation and terms. Some lenders, for instance, will only be interested in providing term debt. In those instances, a bank lender may be brought in by the direct lenders or the private equity sponsor to provide the revolving credit facilities (RCFs).

These RCFs will often sit at the top of the credit structure and require the negotiation of credit waterfalls (a payment scheme that requires higher-ranking creditors to receive interest and principal payments first) and intercreditor rights that take into account the relative ranking of the groups of creditors and the size of the RCF (which is often much smaller than the tranche of term loan debt provided by other lenders).

Raising the bar

After an active 2022 that saw private debt evolve and increase its market share, debt managers have taken a breath at the beginning of 2023. Many managers are ahead of deployment schedules and have thus been able to be more selective when looking at new deals.

Private debt funds have also taken a firmer stance on documentation and deal terms.

Private credit lenders, for example, largely managed to maintain leverage covenants (lender protections that ensure debt levels are not disproportionate to equity and earnings) during the bull market, but these safeguards were often diluted as terms allowed borrowers to claim multiple, uncapped EBITDA add-backs (expenses deemed to be nonrecurring or discretionary, and thus, “added-back” to company earnings).

These add-backs increased leverage in real terms and made it easier for borrowers to avoid tripping leverage covenants notwithstanding increased borrower debt incurrence or declines in borrower performance.

As capital markets have cooled, private debt lenders have been in a stronger position to limit EBITDA add-backs and have focused on restricting add-backs borrowers can claim for nonrecurring items and synergies. Rather than trying to insert additional financial covenants into documents, private lenders have prioritized strengthening the covenants they have by tightening up EBITDA definitions and add-back terms.

Lenders have also drilled down into terms covering call protections and “most favored nation” (MFN) clauses. Call protections prohibit borrowers from buying back or settling debt within a specific period, while MFN provisions ensure that any new additional debt is not provided on more favorable terms than existing debt. During the bull market, MFN terms were included in loan documents but were drafted with many exceptions and carveouts, allowing a borrower to take on material incremental debt without triggering MFN clauses.

Private debt players have closed off many of the workarounds in these areas to prevent borrowers from dodging MFN triggers and to ensure that lenders are being rewarded for pricing deals and taking risk in the current volatile market.

Another area private debt players have reviewed is how they are positioned in capital structures. Following the first round of lockdowns in 2020, private debt players took a flexible approach to where they sat in capital structures and were open to providing subordinated tranches of capital such as payment-in-kind notes and preferred equity.

As credit markets have cooled and private debt players have been able to cherry pick the best opportunities, they have pivoted toward simpler debt structures where they hold first lien debt (debt that is secured against collateral) and sit at the top of the capital structure.

Investors still have dry powder to deploy and are open for business, but the main constraint on new deal issuance has been the supply of high-quality credit opportunities. Private debt funds are ready to do more deals, but only on their terms.

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