In contrast to many industries, COVID-19 reawakened the private debt market, producing an increase in activity during the second half of 2020. Preqin data1 reports that $34 billion was raised by 49 private debt firms in Q2 2020, up from the $22 billion accumulated by 36 managers during Q1 2020.
Institutional investors increasingly rely on specific strategies to obtain countercyclical opportunities. Special situations ($12 billion) and distressed debt ($9.7 billion) accounted for most of the funds raised. Investors followed a similar pattern after the 2008 financial crisis when these asset classes produced outsized returns.2
Preqin data also indicates that 58% of investors now expect their allocations to private debt to increase by 2025.3 Additionally, private debt assets under management (AUM) are expected to grow 11.4% annually, increasing from $848 billion at year-end 2020 to approximately $1.46 trillion by 2025.4
The investment opportunity
The current appeal of private debt is clear. Since the onset of the financial crisis, traditional banks have scaled back their lending books. This preceded the imposition of strict balance sheet capital requirements under Basel III. The resulting shift in lending practices enabled private debt firms to identify a clear opening in the market.
Although bank loans to non-financial companies have surged during the COVID-19 pandemic 5, private debt managers provide a level of agility that traditional financial institutions cannot offer. This nimbleness enables private debt firms to access opportunities which banks may miss, such as the burgeoning work-from-home industry and vaccine research.6
The longer-term outlook for private debt is favourable. Although banks entered the COVID-19 crisis from a strong capital position, their profitability over the next 12-18 months will be constrained by their ability to offer loans, payment holidays and government and central bank-imposed interest moratoriums. Moreover, bank participation in private equity-led leveraged buyouts is also likely to be affected, leading to more private debt funding.7
Long-term returns are also anticipated from distressed assets - specifically companies subject to bankruptcy, insolvency or liquidation proceedings resulting from the COVID-19 crisis. This is of course assuming that their business fundamentals recover once the pandemic dies down.
Getting the Covenants right
As COVID-19 surged, industry concerns mounted over the covenant terms private-debt firms negotiated with borrowers. Pre-COVID-19, an abundance of dry power coupled with investor pressure to execute deals influenced many managers to provide borrower-friendly loans with loose covenant terms.
More traditional and rigorous maintenance covenants insulate lenders from the risk of borrower defaults. As cash flows dissolved, more companies leveraged revolving credit facilities, resulting in the breach of several financial covenants.
The financial crisis unleashed a series of covenant violations requiring private debt firms to rewrite and revise their loan documentation. According to S&P Global, private debt managers replaced conventional leverage tests and fixed-charge covenants with temporary minimum liquidity thresholds lasting approximately 6-9 months8. Covenant terms have become more conservative, although the industry opted against imposing an EBITDAC (earnings before interest, taxes, depreciation, amortization, and COVID-19) as a COVID-19 performance metric for borrowers.9
Creating a more robust operating model
To deliver solid returns for institutional clients, private debt firms must shift from manual-based processing to automated solutions. Technology solutions and platforms will enable them to improve underwriting processes, risk assessments and overall portfolio management. These tools will also:
- Streamline management of deal pipelines and borrower financials.
- Automate invoices, statements and notices.
- Ensure loan covenant maintenance and compliance.
- Enhance client communications and reporting.
Strengthening data-management processes will enable private debt firms to shift from legacy systems, optimize their performance and improve the overall client experience.
Most private debt managers recognise that technology is an essential component for success. This has been reinforced by COVID-19. In a recent study by Broadridge10, it was found that 52% of buy-side firms were looking to create a culture of continuous digital innovation as a long-term transformation strategy.