The gradual exit of banks from business lending due to increased global financial regulation is driving attractive opportunities in private credit, but increased competition among non-bank lenders is causing looser covenants and higher leverage, according to Justin Ferrier, managing director, Asian private credit, at global asset manager BlackRock.
US middle market companies will need about $600 billion dollars of refinancing over the next six years – a figure which dwarfs the dry powder available from US private equity firms, Ferrier recently told the Fiduciary Investors Symposium.
Much of the shortfall will need to come from private credit, in other words credit which is not publicly traded but bilaterally negotiated with lenders other than banks, he said. Similar trends can be observed in Europe, Australia and to some extent Asia.
“So for example in Asia, the private lending market, particularly the special situations market, was dominated by the global investment banks,” Ferrier said. “Each of them ran a number of prop desks. Post-GFC, almost all of those investment banks’ prop desks have closed, creating a big gap in the market for private lenders.”
In Australia, the exit of the nation’s four major banks from many sectors, including construction financing has created a large volume of deals for private lenders, Ferrier said.
However, large amounts of private debt capital have already been raised, and the number of lenders entering this space is increasing, he said.
Out of around 220 global institutions BlackRock surveyed, 58 per cent were expecting to increase their allocations to private credit, with the average allocation change being a 53 per cent increase. Pension funds typically had a 3 per cent allocation and this was generally increasing to around 5 per cent, he said.
The increase is not only due to the retreat of banks from business lending but also due to the sheer attractiveness of private credit for investors, Ferrier said.
“It provides income, it provides an illiquidity premium and higher returns than traded credit. And also credit is increasingly seen as an asset class that provides meaningful diversification. Very importantly, private credit provides better downside protection and recovery rates than high-yield traded credit.”
Broadly syndicated senior loans – the most senior, and, therefore, the lowest risk part of the capital structure – are currently trading at around 250 to 400 basis points over the LIBOR benchmark rate, Ferrier said. This yield increases to between 600 and 700 basis points above LIBOR for the middle market, while distressed debt strategies can earn up to 20 per cent returns.
Covenant-lite
Ferrier’s brief with BlackRock in Asia is to seek out opportunistic strategies that deliver returns in the mid-teens, he said.
Rising competition was compressing spreads for private lenders and also reducing upfront fees, he said. Leverage was increasing, pricing was tightening, and lending terms were loosening, leading to an increase in ‘covenant-lite’ structures.
But while this competition was driving harder bargains in the broadly syndicated loan market where large banks were underwriting and syndicating deals, there was less pressure on pricing, leverage and covenants for smaller deals under-written by a single private lender, Ferrier said.
Many of these deals are unsponsored with direct negotiation between the borrower and lender. They often had bespoke structures such as non-call periods, customised reporting and bespoke covenants, he said.
“About 90 per cent of deals are sponsored in the US and many would argue that sponsored deals are lower risk because you have the potential for better management teams, and you also have access to PE capital that can cure defaults and the like.”
BlackRock’s biggest risk to deals in Asia is that the time spent structuring a deal may be lost when a company’s situation improves a year or so later and BlackRock gets refinanced out.
However, the investment management company has strategies to avoid that scenario, Ferrier said.
“So the non-call periods we try to negotiate are at least two and a half years, sometimes even longer. And to the extent there is an early repayment or redemption, number one is we try to get an equity kicker there if the business is doing really well, and we also try to get some sort of prepayment penalty as well.
“We don’t like shorter duration. If we do the work, and we’re comfortable on the security, we would like to remain in…three to four years is what we’re targeting,” he said.
