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“There is some validation by the Fed that the economy is strong enough that
they don’t need to cut.”
– Brad McMillan, chief investment officer, Commonwealth Financial Network.
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The New Order: Leverage Finance in an Asset Management World (Second of a Series)
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The New Order: Leverage Finance in an Asset Management World (Last of a Series) | |
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While private credit is growing in popularity with both investors and issuers, banks are seen to be struggling with the new order. While arguing for more non-bank regulation to Congress and federal agencies, they are busy trying to start their own direct lending businesses or partnering with established firms.
Given the challenges of holding leveraged loans on their balance sheets, some banks are shifting their strategies to less leveraged, more amortizing so-called pro rata, term loan A offerings. This hearkens back to the 1970s and 1980s before the institutionalization of loans and the crafting of non-amortizing, term loan Bs for CLO, retail, and insurance buyers.
One example is a top US money-center bank focusing its direct lending efforts on middle market non-sponsored borrowers. Debt-to-Ebitda is kept below 4x (under regulators’ radar), and with spreads at least 1% lower than market for LBO financings. These companies are found in manufacturing and industrials as well as service sectors.
Banks are concentrating on niche areas where in-house industry groups give them a competitive edge to finance larger deals. Financials, (e.g. Truist Insurance), aircraft (Bombardier), travel and leisure (Hilton), energy (NorthRiver Midstream), and commodities (US Silica) are instances (and recent issuers) where banks have been competitive for decades.
By providing fund leverage and financing lines to direct lenders, banks are entering private credit through the backdoor. Indeed, when top private credit managers began lending two decades ago, banks often got them started. Post GFC those relationships were critical to maintaining diversified, long-term liabilities’ support through any business cycle.
Meanwhile the largest direct lenders are raising significant LP dollars to accommodate multi-billion-dollar debt financings. These buy-side asset managers have mimicked the sell-side investment banks by developing syndication desks to handle oversized commitments and feed external lending partnerships.
Educating investors clearly on the changing of the guard from banks to non-banks is essential to understanding how each category responds to various economic and market dynamics. Defaults, recoveries, prices, spreads, volatility – all emerge and operate in different ways depending on whether they occur in a bank-style regulated environment.
Fundamental distinctions will remain. Asset management will never be investment banking, though players may use partnerships and acquisitions to supplement their businesses.
Investors will benefit from those distinctions. The gravitational pull towards private capital means better access to higher quality, higher-yielding assets less sensitive to headline news. It also allows for more diversification of risk among sophisticated institutional investors and away from depositors.
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Private borrower covenant (not payment) default rates fell for third straight quarter. | |
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Source: Lincoln International Proprietary Private Market Database
(Past performance is no guarantee of future results.)
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Volatile times, but no distressed boom | |
Capital raising for distressed and special situations strategies has remained at modest levels since hitting a peak in 2019. | |
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Fundraising for distressed and special situations strategies has remained remarkably consistent, even as the long-term effects of the covid pandemic, rising inflation, war in eastern Europe and the continuing fear of a major recession led to a period of severe volatility and economic upheaval.
Fundraising for these strategies only dropped off significantly in 2023, with $36.2 billion raised across 35 funds. It’s worth noting, however, that this reduced fundraising for distressed strategies came against a backdrop of a broader decline in fundraising activity during 2023, across other private debt strategies and throughout the wider private markets space.
Figures from PDI’s 2023 Fundraising Report show that distressed fundraising as a proportion of all funds raised remained consistent with previous years, at 17 percent of all capital secured. However, this is markedly lower than in 2019, when distressed fundraising hit a high point of 26 percent of the private credit market.
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In all cases, distressed remains a somewhat niche offering compared to subordinated and senior debt strategies. Even so, the past five years have also seen some very large vehicles raised to target distressed debt, with by far the biggest being Oaktree Opportunities Fund XI, which beat its target to secure $16 billion of capital for a final close in 2021. Several other major funds also beat their targets, including Lone Star Fund XI, which raised $8.2 billion to surpass its $6 billion target, and Ares Special Opportunities Fund II, which secured $7.1 billion, well above its $4 billion target.
Looking to the year ahead, PDI investor data found that just 18 percent of LPs are planning to increase their commitments to special situations and distressed debt, versus the 45 percent who want to increase their commitments to direct lending in 2024. With a further 14 percent wanting to reduce their distressed exposure and the majority looking to maintain it, we are unlikely to see a major expansion in distressed fundraising in the near future.
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Leveraged Loan Insight & Analysis | |
BDC assets under management reach a new high of US$315bn | |
BDC assets under management (AUM) reached a new high of US$315bn at the end of 2023. The new record represented a 4% increase during 4Q23 and a 15% gain over the course of the year. Breaking it down by category, public BDCs had assets of US$143bn, with perpetual-life BDCs at US$112bn and private BDCs (excluding | |
perpetuals) at US$60bn. At the fund level, the five largest BDCs are Blackstone Private Credit Fund (US$53.3bn), Ares Capital Corporation (US$23.8bn), Blue Owl Credit Income Corporation (US$17.3bn), FS KKR Capital Corporation (US$15.5bn), and Blue Owl Capital Corporation (US$13.5bn). | |
The Pulse of Private Equity | |
Introducing LCD’s dual-track default rate: Sponsors drive distressed exchanges | |
In tandem with LCD’s legacy criteria capturing general defaults of missed payments and bankruptcy filings, LCD is now tracking a separate rate that includes distressed transactions stemming from out-of-court restructurings, exchanges, and subpar buybacks, or so-called “distressed exchanges.” The current payment default rate (excluding distressed exchanges) by issuer count was 2.05% at the end of December. However, LCD’s newly unveiled dual-track default rate (DTDR), which includes payment defaults and distressed exchanges, was 3.8% by issuer count at the end of 2023, up from 1.5% at the end of 2022. Default rates are measured as the TTM calculation of defaults among performing companies in the Morningstar LSTA US Leveraged Loan Index. | |
KBRA Direct Lending Deals: News & Analysis | |
TTM Default Volume, Count | |
Middle Market & Private Credit | |
What Investors Want to Know: Middle Market CLO Manager Assessment Considerations | |
Given the increased interest and overall expansion of the private credit sector, Fitch Ratings highlights key elements of its assessment of the capabilities of middle market (MM) CLO managers that are different (due to relevance) from that of a broadly syndicated loan (BSL) CLO manager. Fitch currently rates MM CLOs by 17 different managers, ranging from large platforms with loan assets under management (AUM) of $60+ billion to less than $10 billion. | |
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In the report ‘What Investors Want to Know: Middle Market CLO Manager Assessment Considerations’, Fitch discusses various assessment considerations it considers unique to managers of MM CLOs. Specifically, four key areas are noted, including capital resources, origination and track record, underwriting and monitoring, and risk management.
Download Report
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Percentage of New Issue First Lien Loans that Cleared with a J. Crew Trapdoor | |
High-Yield Bond Statistics | |
Weekly fund flows source: Lipper | |
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Healthcare is generating significant numbers of restructuring cases
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A guide to distress in healthcare
The US healthcare sector has been beset by malaise in recent months, with the number of restructuring cases lurching to 49 in 2023 from 23 the previous year. Prospects show little sign of improving in 2024, with a dozen Chapter 11 cases already on the table since 1 January, representing USD 3bn of liabilities. Overall, in the year to date (YTD) to 20 March, there have been 31 Chapter 11 applications for total debt of USD 6.5bn, with 11 of these coming from healthcare companies, or 36% of all Chapter 11 filings, per Debtwire’s Restructuring Database.
Approximately one-third of all firms that filed for Chapter 11 protection between January 2022 and March 2024 have been healthcare focused, leading to questions about why there has been such an outbreak of distress in the sector.
Healthcare companies currently battle a variety of headwinds. Chief among these are reimbursement challenges stemming from Medicare cuts, changes in revenue cycles under the No Surprises Act, high labour expenses fuelled by soaring inflation, and steeper funding costs.
Cuts to reimbursement rates for physician pay have depleted medical services providers’ collectibles since July 2022. Medicare first cut its rate by 2% in 2022, and then further reduced the repayment rate by 3.37% in January 2024.
The No Surprises Act - a federal law passed by the government to protect patients covered under individual or group health plans from unexpected hospital bills - came into effect on 1 January 2022. The act forbids health providers from charging patients directly for the portion of medical bills that exceed insurance protection for certain emergency services. It also established an independent dispute-resolution process between plans and providers. Multiple dispute-resolution cases have accumulated since the legislation was introduced, creating a significant collectibles backlog for hospitals.
In addition, some companies tried to take advantage of lower borrowing rates during the coronavirus (COVID-19) pandemic, fuelling growth through debt-backed acquisitions. Surging interest rates put a strain on these over-levered firms, which was further exacerbated by faltering cash flows created by the legislative measures implemented by the government.
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Private Debt Intelligence | |
North American-based private debt AUM hits $1tn | |
Private debt in North America has overtaken real estate in 2023 to become the second largest private capital asset class by assets under management (AUM), topping $1tn for the first time. AUM grew 18% in H1 2023, faster than private equity (13%), and private capital markets overall (11%). 'Investors are attracted to the defensive nature of private debt and the high returns available, believing that bank retrenchment and continuing liquidity concerns presents an investment opportunity. The dry powder held by private debt funds ‘rose to $350bn, just over 30% of total AUM and up from 28% at the start of the year’, according to Preqin’s Charles McGrath, AVP, Research Insights in ‘Alternatives in North America 2024’. | |
March Update: Middle Market Deal Terms at a Glance | |
This publication is a service to our clients and friends. It is designed only to give general information on the market developments actually covered. It is not intended to be a comprehensive summary of recent developments or to suggest parameters for any prospective financing opportunity. | | | | |
