An exclusive interview with industry experts from Piper Jaffray Companies and Wynnchurch Capital

Today, the world's capital markets are saturated in liquidity due to government and central bank stimulus and easy money policies stemming from the 2008 credit crisis. These unprecedented policy moves have caused global equity market valuations to spike, the money supply to significantly grow, and institutional investors to become flush with cash.

Much to the delight of jubilant private debt fund managers, central bankers around the world have no plans of pulling this liquidity punch bowl from the party anytime soon. After all, the US$600bn private credit industry stands as one of the biggest beneficiaries of post-crisis central bank policies, such as QE, NIRP, ZIRP, which aimed to reignite economic growth through easy credit. At the very least, many private debt funds have been able to extend lifelines to distressed or fledgling companies, who would have been otherwise shut out from capital markets as increased regulation and risk cause traditional lenders to tighten underwriting standards.

Private debt fund managers and central bankers rejoice.  

And yet, more revelers can be found as this occasion, courtesy of omniscient central bank hosts. Yield-starved, long-term investors, such as pension funds and insurance companies, have only been too happy to grow their allocations to private debt funds thanks to favorable risk-adjusted returns and stellar yield. From an investor perspective, private middle-market loans registered a mean return of 6.21% and Sharpe ratio of .84 from 1999 – 2015. This risk ranked better than broadly syndicated loans and high-yield bonds while the returns were similar, but with lower volatility as measured by standard deviation, a TIAA Global Asset Management report found. Institutional investors favor direct loans and mezzanine strategies over venture debt, distressed debt and special situations.

Private equity firms are joining the liquidity punch-drunk bunch as US buyout shops have sponsored half of middle market loans mostly in the form of mezzanine, which plays an important role in buyouts' debt stack. The same TIAA report found PE general partners' equity capitalization of 40% implies more than US$800bn in new loan demand will occur over the next several years.

Let us not forget this party’s guests of honor: the myriad of distressed or growing middle market companies who were oh-so-close to being shut out from the good times. While the world is awash in liquidity the market will remain open to almost any issuer. This wall of money also enables refinancing for weak companies, lower default rates and, importantly, a lower net issuance in the bond market than otherwise would have been.

So, what could possibly dampen the spirits of those who celebrate within this house of mirth?

True, some private credit managers have recently artificially boosted their internal rates of returns using lines of credit, with durations extending to three years from the typical 12 to 18 months. This has caused some concern for investors and market observers, as credit lines tend to range from 5% to 40% of fund capital and are used so that general partners do not have to call capital from their investors as often.

However, what has many troubled, as I found out while conducting research into Debtwire's annual US Middle Market Financing Forum, is that many new debt fund managers, who lack experience in the middle market, are rushing in due to competitive pressure. It's one thing to structure a high-yield bond or syndicated leveraged loan deal for a S&P 500 company, than say, structuring a US$250m direct loan for a regional family-owned company that has an EBITDA of US$50m. True to form, private debt funds use a thorough private-equity style due diligence and work closely with the borrower's management teams to structure loans by vetting financials and other critical documentation. Such prudence is a hallmark of private debt lending. In fact, funds have earned a reputation for not only providing their investors with yields significantly higher than offered by similarly-rated public debt, but have achieved lower default and loss rates compared to public high-yield bonds due to strict covenants, management oversight and other safeguards. However, many new debt fund managers, who hail from banks that underwrote high yield and leveraged loan issuances, whose primary goal was to syndicate the deal and then sell the loans to investors, lack that background. 

“Quite often you will see senior principals who come from more of a flow credit background or a liquid credit perspective move into the private debt space. These professionals are more accustomed to being price-setters and term-takers, meaning they bought into syndicated deals as opposed to applying a documents- and diligence-heavy approach through direct contact with borrowers,” said Richard Shinder, who is Managing Director and head of PiperJaffray's Restructuring Advisory Group. “With this approach there is a risk of missing key credit factors and critical documentary protections as part of their origination and underwriting processes.”

Michael Teplitsky, managing director of Wynnchurch Capital, agrees: “I think that probably too much capital has come into the middle market, which has created a supply and demand imbalance. There's more risk taking and speculation from these credit groups. It’s especially an issue for cyclical industries, like for example, automotive.”

“Even though (debt fund managers) have the experience of providing capital in the credit markets through different cycles, I think from an organizational perspective, these groups don’t have the adequate workout capabilities. So, if a downturn were to come, let’s say in 12 or 18 months, these groups would have challenges in being able to adequately react to problems with the portfolio. Also, and this is more in the upper end of the middle market, where it’s very competitive. These groups are competing on terms as well, so covenant restrictions are smaller and these groups don’t have as much power to exert influence when things go bad,” Michael added.

Once central banks begin to remove crisis-era policies, which the US Federal Reserve is doing by raising rates and soon embarking on shrinking its balance sheet, fears may arise that those funds that were more speculative and less diligent in underwriting will suffer losses from defaulting corporates.

“As I survey the market and think about the platforms that are likely to be the most durable as the cycle shifts”, Richard said, ”among BDCs, private debt funds, credit opportunity funds, and others who have originated direct credit in the middle market, I believe those that will prove most seaworthy as we enter choppier waters will be those that either are more disciplined in their underwriting, portfolio management, and workout approaches, either as a result of having people who come from a higher-touch credit origination environment and/or those parties who have really stuck to their knitting with respect to credit niches where they specialize or have a true edge over other market participants.”

Regardless of what may come over the next 12 to 18 months in terms of interest rate movements, corporate operating profit margins, earnings, central bank policies and money supply both Michael and Richard expressed opportunities will endure for private debt funds in a variety of sectors.

“I think one sector that comes to mind is energy. Even though you’ve had a choppy upturn in the cycle for energy companies, whether it be upstream or services- and equipment-oriented companies ...  (traditional lenders) have been slow to come back into the marketplace and originate credit for companies who are now doing better, but are on the wrong end of the working capital cycle. I think that’s created a real opportunity for non-regulated direct lending market participants to fill the void that’s been left by the commercial lending sector,” Richard said.

Michael anticipates that safer areas for capital to come in will be in “pockets” of the food industry, which is generally perceived to be a defensive sector. Richard is especially optimistic for new money coming into the restaurant industry.

“That’s a difficult space, because unlike retail there’s really no tangible asset value against which to lend. But it’s also a space that doesn’t experience the same macroeconomic headwinds that retail does, so its effectively brand-based lending, and as a result, it’s a space with winners and losers,” Richard said. “There are no barriers to entry when launching a restaurant concept, so I think to the extent that lenders or market participants feel that they have the resident expertise and understanding of restaurant industry economics, that it is a space that, from a supply and demand for credit perspective, the dynamics are favorable for providers of capital.”

So, whether you run an oilfield service company or restaurant, if you can show cash flow, chances are you can work with a private credit entity to lend you money. With 284 private debt funds currently aiming to raise a combined US$112bn in the market, let the good times roll. 

To learn more about  the role of private debt funds role in restructurings please visit this link to review  Debtwire's annual US Middle Market Financing Forum, which will be held  September 14 in New York City.

Matt O'Brien Content Editor Acuris

Follow Matt on Twitter @MattobrienMM or connect with him on LinkedIn.  

Matt O'Brien is content editor for Remark, the sponsored events and publications division of Acuris, overseeing the research and editorial input for events. Matt works with the editors and reporters of Acuris' various publications to ensure the company delivers industry leading conferences. He has spent nearly 13 years in the news and finance industries. Matt has a political science and international studies BA from Rutgers University.