Private credit’s safety blanket

Receive free Private credit updates

We’ll send you a myFT Daily Digest email rounding up the latest Private credit news every morning.

Good morning. Nvidia’s second-quarter earnings absolutely demolished Wall Street’s expectations. The company reported $13.5bn in revenue, over $2bn more than the consensus expected and double the year-ago number. It’s targets for next quarter were equally impressive. The stock rose 6.6 per cent in late trading. We’ve compared Nvidia in 2023 to Cisco in 2000 — but back then Cisco was only growing about half as fast. Should we relinquish our scepticism? Email us: robert.armstrong@ft.com and ethan.wu@ft.com. 

How thick is private credit’s equity cushion? 

We have written a series of newsletters about private credit and whether it can deliver on the promise of equity-like returns without equity-like risk.

Talking to people across the industry — direct lenders, managers of business development corporations, and so on — one idea that keeps coming up is that private credit investors are protected by large equity buffers at the company level and by low leverage at the fund level. Lenders into leveraged buyout deals are insulated from losses by the increasingly large equity investments of the PE deal sponsors. And private credit vehicles themselves often contain a big slug of equity. BDCs, for example, generally have debt/equity ratios of just 1 or 1.5. This means credit losses do not have as much potential for destroying value as in more leveraged vehicles (such as banks!).

The basic idea is that there can be a lot of losses before creditors get badly hurt. There is a good deal of truth in this. But it is important to be clear about exactly which creditors are protected, how, and to what degree. 

Here is Michael Arougheti, chief executive of Ares, back in May (as flagged by Robin Wigglesworth over at Alphaville):

The big misunderstanding [is that in] the bulk of the private credit markets . . . [loans] are underpinned by cash equity from a sophisticated institutional equity owner and a sophisticated management team, and we are going into this current cycle with more equity subordination in all of these capital structures with better underwriting than we’ve ever seen . . . 

The math would simply tell you that if we’re talking about real losses in the private credit asset class, you will have blown through $2tn to $3tn of institutional equity, but people don’t like to talk about that fact. 

Along remarkably similar lines, one executive at a big BDC put this to us:

You cannot run math resulting in a creditor losing a dollar. You’d need a 40 per cent default rate and 40 cent [on the dollar] recoveries to blow through 50 per cent of the capital structure. I understand the point that private credit hasn’t been tested, but [historically normal] 10 per cent default rates and 70 cent recoveries still wouldn’t result in half of the equity getting evaporated.

What constitutes “real losses”, though? If all the equity has been lost, the company is worth less than the loans against it, and the lenders lose some of their capital. In that specific sense, a bigger equity cheque from the sponsor, and therefore a lower loan-to-value ratio, is indeed a help. And the sponsor cheques have been getting bigger. Buyout loan-to-value ratios have been falling in recent years. Here, from Ares, is what LTVs looked like before the financial crisis and the pandemic:

Now, as banks pull back from the syndicated loan market and financing conditions tighten, private credit lenders are able to extract even bigger equity cheques, and lower LTVs. A representative LTV these days looks more like 40 per cent, several people told us.

However, a company remaining more valuable than its debt does not imply that the debt investors’ investment has retained all its value. Imagine a company that was once worth $100mn, with $50mn in debt (a 50 per cent LTV ratio). If the company is now worth less than $50mn, it is likely facing serious cash flow problems, and is struggling or failing to make its debt payments. What’s more, the lenders are facing the prospect of owning the company, a huge, time-consuming, expensive pain in the ass. They may not be able to realise all of that $50mn by the time the company is sold.

Remember, in this connection, that equity layers are not money in the company’s or fund’s bank account. “The equity doesn’t pay debt service. It’s theoretical, not a pile of money there to be resourced,” as Christina Padgett, head of leveraged finance research at Moody’s, puts it. Once the equity is gone, the promise of high-single-digit creditor returns is probably long gone, too.

The big equity cheque from deal sponsors does, on the other hand, signal the depth of those sponsors’ commitment. If a company is struggling with cash flow, its sponsors may provide financing or stump up more equity as part of a refinancing — as they did in the recent case of the fintech company Finastra.

But this is a hope, not a guarantee, and there are misalignments between PE and PC. One senior direct lender notes that while a top PE shop can afford to take heavy losses on, say, a quarter of its portfolio, private credit’s returns are much more dependent on preventing losses. “PE equity cheques don’t keep you safe if you haven’t done good underwriting on your own,” he says.

To get a sense of what full-cycle private credit losses might look like, Padgett and her team look at the history of “distressed exchanges”. These are voluntary debt restructurings to avoid bankruptcy, often by PE-sponsored companies with floating-rate debt (and thus resembling what many direct lenders invest in). Between 1987 and 2019, the average creditor in a distressed exchange recovered a respectable 72 cents on the dollar. But two in five distressed exchanges did not ultimately stop a bankruptcy. In those cases, recovery rates looked much worse; the average creditor lost half of what they put in, with some losing more.

The point is that blowing through half a company’s value in a distress situation is not just possible, it’s relatively common. Just this year, a change to medical billing laws wiped out KKR’s $3.5bn equity investment in bankrupt Envision Healthcare. Senior creditors will probably take losses.

Zooming out, a lot of people in the private credit industry have told us that the asset class can offer high single- to low-double-digit returns, while offering a risk profile as good as or better than that available in the high-yield bond market. That is to say, the promise is equity-like returns without equity-like risk. The promise rests on two foundations: extra spread on the returns side, and high equity buffers on the risk side.

The extra spread, the industry argues, comes from providing borrowers with certainty, privacy and flexibility that public bond markets cannot. Sceptics argue the spread just comes from taking extra credit risk. We disagree with the sceptics, but expect this spread to diminish over time as more and more capital rushes into the industry. The equity buffer, meanwhile, will indeed help lenders avert wipeout losses. But they will not stop a real credit cycle from eroding the high returns that private credit has enjoyed in recent years. Equity returns without equity risk is a violation of the laws of financial gravity, which come for all asset classes eventually. (Armstrong & Wu)

One good read

Finally, a good use for metaverse avatars.