Q. What is your perspective on the current state of the lending markets compared to the last cycle in 2008 and 2009?
Barry (Antares): This cycle began much more abruptly than the previous one. It felt like it all happened in about a week, whereas the last cycle had a more gradual onset. Given that abruptness, I give the sponsor community enormous credit for jumping on the situation very quickly. Many have done 13-week cash flow analyses, even in companies without known issues. They’ve become very prescriptive in that regard.
Another difference from the last recession is the speed with which borrowers have tapped into their revolvers. And, as you would expect, companies operating in certain industries have taken advantage of their revolvers more than others.
Riceman (Varagon): The catalyst for the 2008-2009 recession was very different than the catalyst for the current downturn. Back then, we experienced a true financial industry crisis, while today we are experiencing a drastic decline in demand for a wide range of goods and services as a result of shelter-in-place requirements—not a break in the financial system itself. Banks are far better capitalized today than they were then. There are also fewer banks active in middle-market sponsor finance today and more private capital providers. Many of the firms active in the middle market today are a product of regulations created after the Great Recession.
Long (Maranon): Lenders are not only better capitalized today, their sources of capital are more diversified. In 2008, it was not unusual for a lender to rely solely on a single funding mechanism—a collateralized loan obligation (CLO) platform, one large investor, or a public business development company (BDC). Lenders today typically incorporate multiple funding sources into their platforms. As an example of lender liquidity today, the wave of borrower revolving line of credit draws in late March 2020 was mostly honored.
Finally, the source of lenders’ capital has shifted to more sophisticated investors. In 2008, the banks and their depositors were the largest suppliers of leveraged loans for private equity-backed transactions. As an asset class, private credit was not even on the radar screen for most institutional investors. Today, banks supply a minority of the capital to the leveraged lending market, while credit funds and other direct lenders backed by longer-term institutional capital with the scale and investment horizon to ride out the crisis predominate (Figure 1).
Broeren (PNC): This is more indicative of a wartime-type recession, in the sense that we have a nearly global work stoppage. We haven’t really seen anything like that before. The mitigant is that the banks are certainly better capitalized than in the 2008-2009 recession. And while it’s challenging to not know when we are going to emerge from this, once there is clarity on containing the health component via a vaccine or therapeutic, many believe the economy will be fundamentally strong.
Q. The average bid for high-yield loans in the secondary market dropped to the high 70s in March, and has seemingly bottomed given the swift recovery thus far. How does this compare to 2008-2009, when average bids dropped as low as the high 60s, and what is different about the demand for these loans today?
Barry (Antares): Again, we had a financial system crisis back in 2008 and 2009, and as conditions continued to decline, there were various financing vehicles that needed shoring up. I think the general perception among debt holders today is that because this is a health crisis, and not yet a financial crisis, it will bounce back more quickly, and they therefore don’t need to sell those positions. We’ve seen a little bit of selling upfront, but we think we’re not going to see much more of it going forward.
Long (Maranon): The leveraged loan market went into the Great Recession with a large overhang of fully committed leveraged loans in the pipeline. As rating agency downgrades forced CLOs to sell loans to preserve their structures beginning in the third quarter of 2007, this overhang added supply to the market and further depressed prices. Prices bottomed in the fourth quarter of 2008, and did not fully recover until 2014.
Going into the current crisis, however, there was not an oversupply of underwritten but undistributed leveraged loans. And, as institutional investors have increasingly accepted private credit as a legitimate asset class, the presence of retail loan funds has injected much more liquidity into the market. We do feel that credit managers today who are managing CLOs and operating with leverage lines will see some downgrades in their portfolios in the second and third quarters of 2020, but those downgrades will not be as deep or as quick as the last recession.
Source: S&P Global
Schumacher (Varagon): How single-B loans trade going forward remains to be seen. While I don’t expect to see single-Bs reaching the higher 90s any time soon, if the economy comes back online and people begin to reopen their businesses, it should happen over time. So, the question is more “when” than “if.” Will we see it reach these levels over three, six, or nine months, or longer?
If the new-issue markets remain sluggish, that will also prop up secondary trading levels. If the new-issue markets are open, but not as robust as they were, then excess money previously deployed in the primary market must go somewhere else. In other words, CLO managers will seek to keep their vehicles invested via secondary trades. This belief supports a continued flight to quality and explains why double-B names are currently trading disproportionately higher than single-B names. I expect this pattern to continue until we begin to see light at the end of the tunnel with respect to economic activity.
Elliott (PNC): Just as we saw with the last recession, loan prices bottomed and brought interest from a wide range of buyers, which caused a fairly steady upturn in the institutional market over time. There’s no reason the same thing won’t happen again. I think the most unpredictable part about this whole thing is the point at which we see conditions returning to normal.
Coming out of a shock like this, investment-grade debt will always be the first to open up because investors are sitting on cash and need to put it to work to generate returns. A few weeks ago, funds also started to flow into high-yield loans, and now we’re starting to see capital move into the leveraged loan market. The first institutional issuances were rescue finance, intended to enhance liquidity, and were very expensive capital. That has quickly evolved into more typical financings. We’ve even seen some lower-B issuances at reasonable coupons, albeit OIDs matching where the secondary market is. And so, if the overall secondary market for low-B risk is in the upper 80s or 90 cents on the dollar, that’s where they need new issuance to be launched to make it compelling.
Q: Which industries have shown resilience in this environment, and how does that compare to industry performance in 2008-2009?
Long (Maranon): It’s early, but certain sectors of healthcare are bright spots today, as they were in 2008 and 2009. Similarly, we’re seeing our software-as-a-service (SaaS)-based businesses with recurring revenue streams hold up well. Conversely, some of the businesses that held up well in the last downturn have been impacted in ways that we would not have expected. Food distribution businesses, for example, that are heavily reliant on the institutional or restaurant channel have been negatively impacted by the shutdown. Another example of an industry we have seen hit harder in the COVID-19 shelter-in-place era is the elective healthcare services sector, including dental, physician, dermatology and ophthalmology practices. However, we would expect these businesses to bounce back quickly as shelter-in-place restrictions are lifted, assuming providers have adequate personal protective equipment.
Elliott (PNC): Software and other businesses with high levels of contractual revenue streams appear to have held up well. Conversely, we’ve seen more challenges in certain subsegments of healthcare, gaming and hospitality, manufacturing and machinery, entertainment and leisure, metals and mining, textiles, consumer discretionary, and home furnishings.
Q: Deals over the past few years have seen higher levels of addbacks. How do you anticipate evaluating COVID-19 addbacks, and what level of diligence/support will your committee require to underwrite them?
Long (Maranon): We think we’ll start to see revenue- and cost-related addbacks for COVID-19 as the crisis begins to ebb, as second-quarter 2020 borrower compliance certificates roll in, and as investment banks launch postponed deals or restart those pulled from the market. We would also expect some borrowers to ask for Payroll Protection Program loan proceeds to be added back to EBITDA, a similar concept to business interruption insurance. The difficult addbacks to accept will be nebulous buckets for “lost sales” or “increased supply chain costs.” Data will be critical to support pro forma adjustments, and well-advised management teams should be tracking metrics at the most granular level possible. For example: Which customers experienced shutdowns, and at which specific plants and for how long? On the cost side: What were the changes in logistics costs related to specific changes in rates, quantities, point of origin and destination?
Elliott (PNC): The market is in triage mode, and discussions with investors, especially on the non-regulated side, suggest a big focus on improving structures, managing risk and maximizing returns.
From an existing deal perspective, investors will do what they need to do to protect their portfolio investments. In some cases, they are allowing for COVID-19 addbacks, and, in other cases, they are just expanding the covenant level being measured. The more data a management team can provide to substantiate a covenant ask, the less resistance it will encounter. There will be a focus on looking for ways to potentially include collateral that was previously excluded, being creative with asset coverage, and instituting enhanced call protection measures, whether those are no-call periods followed by hard-call periods or longer soft-call protection.
Q: Given the swift onset of COVID-19 and the impact on companies, do you expect lenders to be more patient in giving companies an opportunity to recover or being swifter to act on defaults?
Barry (Antares): In the middle market, we have a tight-knit lending community, and you’re going to see more patience. There’s a sense that everybody’s in it together. Sponsors are solving some of the market’s liquidity challenges, lenders are solving some of it, and everybody’s doing their part to make sure that we’re moving forward. I think everybody wants to work with the sponsors to get to the other side.
Jander (Maranon): When you look at leverage providers, none of them want to see anybody go down. I think the approach has been relatively collaborative thus far in terms of how leverage facilities are working, and the loan modifications within them.
The banks are relatively well capitalized, so I don’t see them panicking and trying to liquidate a leverage facility when they can “lend it through.” That’s what we’re doing with our borrowers in situations where we believe a patient approach will pay off. It’s better to let liquidity stay in the business and nurse it past the crisis.
Lenders don’t want to take the keys to a business—they’re not equipped. They’re equipped to manage a workout process. But when you start grabbing the keys to portfolio companies, that creates an entirely different infrastructure need. It’s also not the strategy than your limited partners hired you to manage for them. I don’t think anybody wants to see that.
Riceman (Varagon): In general, the market is taking a “shared solution” approach. Lenders and private equity sponsors are working cooperatively and collaboratively to ensure a company has adequate liquidity until its business can resume normal operations. That’s especially the case for those companies that are experiencing issues entirely related to COVID-19.
Elliott (PNC): For the most part, we haven’t seen banks draw a hard line for companies with sound business models that are being impacted by COVID-19. When those businesses need help to get through this period, we’re seeing that get done.
If you look at amendment activity, in the last recession covenant activity was evenly split between the pro rata and institutional markets. In 2020, most of the amendment activity is in the form of banks and pro rata, and less than 10% is in the institutional market. And with roughly 80% of today’s institutional market cov-lite, there isn’t much lenders can do until borrowers stop making payments. And if there are other liquidity providers and enough flexibility in the credit agreement, it could be a significant amount of time before we see companies in true distress.
Lenders we’ve spoken to see the current economic challenges as a very different animal than the Great Recession. With banks and the overall economy on stronger footing, they are generally optimistic that recovery will be swift once COVID-19 has been brought under greater control.
At the same time, lenders acknowledge that they have been surprised by the suddenness and wide scope of the current economic environment, citing impacts in industry sectors previously perceived as recession-resistant. They also remain committed to balancing their own financial health with that of their customers, putting long-term borrower recovery ahead of short-term action against defaults. Likewise, lenders reiterate their strong preference for acting as a growth engine for businesses versus holding the keys to daily operations.
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Published June 2020
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