By Michele Kovatchis, Antares Capital
It’s been a quiet time for workout teams, with the U.S economy still in its longest expansion since WWII.
When the next downturn will hit is unknown, but lenders, borrowers and investors should consider some key factors likely to affect the next down cycle.
Some have new dynamics and implications compared with how these factors played out during the global financial crisis of 2008.
Meantime, investors looking to minimize losses through the next cycle should ensure that the lenders they choose today have the team and experience necessary to support them when the market turns.
This goes as well for sponsors who appreciate the benefits of patient, flexible and creative lenders that will work to maximize enterprise-value creation throughout a cycle.
- EBITDA Adjustments: There is nothing new about debt leverage climbing to peak levels late in a cycle. But this time around true debt leverage may be understated due to a new level of acceptance of EBITDA addbacks. These involve adding back expected benefits from synergies, cost savings and other adjustments to historical EBITDA. While some addbacks may be well founded, others are more speculative.
- Increased covenant lite: At the prior peak in 2007, only about 1 in 5 syndicated leveraged loans issued, and virtually no middle-market loans, were covenant lite – loans without financial-maintenance covenants. Today, covenant lite accounts for about three quarters of institutional leveraged loans and about a quarter of sponsored middle-market issuance. Consequently, lenders today typically have less advance notice of performance issues, thereby restricting the ability to proactively address potential operational and capital-structure issues sooner in the process.
- Looser credit terms: Loan document terms continue to loosen, with fewer restrictions on the use of credit party funds and more incremental debt capacity, etc. This may empower borrowers to attempt desperate last-ditch, and potentially misguided, efforts to fix problems.
- New entrants. Private credit has seen record fundraising in recent years. Some private credit managers are relatively new to the space, with little or no experience managing through a down cycle or having dedicated workout capabilities. Private equity funds also are increasingly dabbling in direct lending and/or private credit investing and may face unique legal constraints. It is uncertain how these players will behave if their portfolios come under stress and their bank lines shrink.
- Complex Capital Structures: Several factors in today’s financial landscape could make consensual restructuring more difficult to complete versus the GFC:
- Leverage at different corporate levels (i.e., holdco debt or separately financed divisions) results in disparate creditor groups. As a result, creditors may focus less on consolidated valuation, but rather will be motivated primarily to maximize value for the entity to which they have exposure.
- Lenders are investing across the capital structure of a borrower to diversify exposure. As a result, restructurings become more challenging when investors are managing returns for investments at varying levels of a capital structure.
- Distressed hedge funds are sitting on investment dollars to deploy and their motivation can be materially different from institutional or primary lenders.
- Highly engineered credit and intercreditor documents create increased potential for disputes.
While market dynamics may vary in the next down cycle, the key desirable attributes to consider when choosing a lender are largely unchanged.
These include time-tested credit discipline in underwriting and portfolio management; a large, diverse portfolio; strong origination capabilities that enable the lender to be selective and lead the transaction; a solid permanent capital base (e.g., not subject to the vagaries of the stock market’s net asset value assessment); and experience, including a dedicated workout team and a proven track record of successfully managing through previous down cycles.
Michele Kovatchis is a senior managing director and head of the credit advisory group for Antares Capital. Michele can be reached at +1 312-638-4065 or firstname.lastname@example.org