Will direct lenders prove to be wolves in sheep’s clothing?
Direct lenders and debt funds have always pitched themselves as being more suitable partners for businesses than banks, bondholders, or other institutional lenders. When the going gets tough, they can be quicker to waive covenants and offer new money than a less concentrated creditor group. But this also puts them in pole position to take the keys from a business should things go wrong — which we may see happen this year.
Concentrated creditor groups have benefits. As direct lenders started to muscle into mid-market lending in Europe, they were keen to advertise these advantages, particularly to sponsors.
Direct lenders argue, with good reason, that they can be faster at making funding commitments. They are smaller and less bureaucratic than banks; and with fewer counterparties involved, when speed is of the essence, it’s better to deal with a single creditor.
They can also brag about offering flexibility. Highly levered or complex deals, lending to non-traditional sectors, and trades with unusual structures all are sweet spots for direct lenders, since it can be a struggle for banks to parcel up and syndicate those kinds of risks.
Then there is the sense of partnership some funds claim to offer. They can be flexible about bolt-on acquisitions, carve-outs, dividends and other corporate actions in a way that most institutional lenders cannot.
They expect good access to management information but can use this greater understanding of the business to be more accommodating to new corporate approaches. They might even be happy to put in new money, to help a sponsor fill out its investment thesis.
In public markets, lenders and investors have few special reasons to trust management teams or sponsors. Access to management is rare and information flows are heavily controlled. Parsing quarterly reports becomes a contest between analysts seeking to uncover the truth and management seeking to obscure it.
But direct lenders take concentrated positions. A fund may make perhaps 10 loans, rather than the hundreds that end up in a CLO. They expect to go deep on every company, and have an intimate understanding of its business drivers, plus better information and access to management. After all, if you’re a firm’s only creditor, it’s a simple matter of picking up the phone.
Running the business
So far in the Covid-19 crisis, this has mostly worked well. But the pandemic is not over yet.
Direct lenders, as well as their public market counterparts, have been largely willing to waive leverage covenant breaches caused by the pandemic, often in return for minimum liquidity commitments. The funds can get a fee of 50bp-150bp for the waiver, or an incremental pickup on the margin the more levered a company becomes.
Few institutional lenders, be they banks, CLOs, or loan funds, have had much appetite to take the keys from struggling sponsors.
There have been a handful of cases involving the most challenged businesses — Swissport or Europcar, for example — where loans and bonds ended up in the hands of distressed debt specialists able to parlay their positions in capital structures into equity ownership.
But aggressive enforcement isn’t in the playbook for most par lenders. They don’t have the skills, spare time or appetite to become business owners rather than financiers. Unless they sell their positions into the distressed debt market, assuming transfer restrictions permit, they often lack the coordination to push through a restructuring on the most advantageous terms.
That’s not always true for direct lenders. A number of the largest private debt lenders sit inside larger alternative asset managers, often with substantial private equity and distressed debt interests. They have the skills and the appetite to own businesses on the cheap.
The very partnership model that gives direct lenders close insight into a business also gives these lenders a clear sense of the opportunities available in enforcing security and taking over a struggling company. They understand the strengths and weaknesses of existing management and strategies, the competitive landscape, risks and opportunities.
Their facilities agreements also often have teeth that aren’t present in public markets. Maintenance covenants are usually present, guarantee packages are stronger and security more enforceable. The flip side of the informal flexibility which the direct lenders are willing to grant sponsors is a more restrictive formal document, than increasingly lax term loan ‘B’ or high yield bond documentation.
If direct lenders do want to play hardball in a restructuring, taking over a struggling firm or extracting its value, they usually only have themselves to negotiate with. They aren’t always the sole lender to a business, but it’s likely they’ll be in a small club, so can skip the awkward phase of forming creditor committees, finding advisors and aligning interests. Again, a few phone calls will suffice.
Put all that together and it might turn out that some direct lenders end up swallowing the businesses they lent to as partners. That’s not necessarily a bad thing — the debt-for-equity swap is a mainstay of corporate restructuring for a reason — but it might sit badly with sponsors and other owners who bought into the direct lending hype. But for direct lenders, which face a choice of small margin and fee gains for covenant waivers or taking over the business and selling it four or five years down the line — the latter might be the more lucrative choice.
A safeguard, for some, will be a fund’s long term reputation. Direct lenders remain in dire need of new deals and vie with the public markets, which have proven most accommodating since being underpinned by central banks, and banks, which are growing increasingly desperate to hit their loan budgets.
Funds that gain a reputation for being trigger-happy in enforcing security over companies grappling with the impact of the pandemic will struggle to find attractive deals in future.
But with Covid-19 vaccines rolling out and the end of lockdowns in sight, the temptation may still prove too great in some cases, and sponsors might end up rueing the day they raised funds from direct lenders and helped to “disintermediate” the banking system.