FREE MEMBERSHIP Includes » ABL Advisor eNews + iData Blasts | JOIN NOW ABLAdvisor Gray ABLAdvisor Blue
Skip Navigation LinksHome / Articles / Read Article


The Next Credit Cycle: Extinction or Non-Event?

Date: Nov 07, 2017 @ 07:00 AM
Filed Under: Industry Trends

Since 2013, an average of 37 private credit funds have raised $22 billion of capital every quarter, and this trend shows little sign of slowing down. At the start of Q3 2017, there were more than 300 private debt funds actively raising in excess of $130 billion in capital, with over 60 percent of these funds targeting North America as their primary geographic focus. As a strategy, direct lending has been especially en vogue in recent quarters, representing slightly less than half of the private debt capital being raised in Q2 2017¹.   

No segment of the debt capital markets has grown or evolved more than middle-market credit. These changes have been largely positive, particularly for borrowers. The dramatic increase in the number of lenders and the capital allocated to middle-market direct lending has driven increased competition for loans, resulting in compressed yields and borrower-friendly structures — including the return of “cov-lite” deals, and the newest emerging trend known as “dili-lite” deals.   

Traditional lenders have also benefitted from this market expansion. Competition for new loans aside, increased liquidity and greater investor appetite for middle-market loans has moderated distress within traditional bank portfolios — a trend that is likely to continue. Risk has shifted from banks to private lenders as challenged credits that no longer have a home within banks are often able to find financing from private credit investors. Additionally, the advent of these newer market entrants means that lenders of all stripes can look to monetize credits in a more active secondary market. These benefits have translated into a persistently benign default rate environment. The S&P/LSTA Leveraged Loan Index — which tracks the largest facilities in the leveraged loan market — recorded a default rate below 1.4% in September 2017; and the reported default rate was slightly lower across the commercial and industrial (C&I) loans made by commercial banks.

Despite the benefits and the apparently endless supply of capital allocated to middle-market private credit, lenders may want to start looking over their collective shoulder. The stated default rate likely understates the true level of default in the market. Free of the restrictions placed upon traditional bank lenders, private lenders seized market share by offering borrowers more creative structures and greater flexibility, absorbing risk along the way. Loans with greater default risk have migrated to lenders that often have less stringent reporting requirements and greater latitude in how problem loans are addressed -- often resulting in    lending deeper into a turnaround and/or allowing these lenders to “paper over” impending defaults. Thus, the new paradigm in middle-market credit is one which involves a variety of lenders — banks, Business Development Companies (BDCs), and private lending funds — which is impacting the published default rate. Additionally, the rise of private credit is affecting the resolution of problem credits, amd will continue to do so.

Traditional Banks

Traditional banks have been forced to adapt to the recent onslaught of competition from private lenders, especially in the middle market. Consequently, banks have reduced interest rates and accepted borrower-friendly loan features in order to secure new transactions, and avoid refinancing of existing credits. The competitive tension has extended beyond documenting and structuring the business agreement, as banks are also conforming to shorter diligence windows such as “dili-lite," and quick commitments have become more and more common in the middle market.      

The natural corollary is documentation with fewer default triggers and relaxed monitoring rights, which allows challenged credits to migrate deeper into distressed territory before the bank is in a position to take steps towards a resolution. As a result, bank workout groups may be “shadowing” troubled credits that have not yet defaulted, but generally have fewer active credits in more advanced stages of distress.

One of the few constants in lending has been the motivations of the workout function at traditional banks. Strategically speaking, the consistent objective continues to be either monetization of the position or rehabilitation of the credit. Tactically, the monetization alternatives have improved significantly, especially in the middle market. Borrowers that no longer fit the profile of a bank credit can often refinance with an alternative lender. The small-to-medium size bilateral or “club” loans, which were once completely illiquid, can now be sold in a reasonably liquid secondary market. And, if neccessary a sale of the company – a stalwart monetization tactic – is supported by robust M&A activity. The flood of capital that has been problematic for the origination and underwriting functions has been magnanimous to the workout function.

Business Development Companies

In many ways, Business Development Companies (BDCs) are the original non-bank lenders. In existence since the 1980s, BDCs have historically capitalized on various regulations and market fluctuations that restricted leveraged lending by banks. This caused many of “nonbankable” middle-market borrowers, as well as some “bankable” borrowers, to migrate to BDCs. Like their traditional bank counterparts, BDCs have experienced the same ultra-competitive lending environment, suffering similar rate compression while absorbing more borrower-friendly structures.

Somewhat similar to bank lenders, these publicly traded BDCs are subject to reporting requirements; including indications of any loans that are on non-accrual status (i.e. the borrower is not fulfilling interest or payment obligations). Public BDCs are also required to mark positions to market value in their SEC filings — which can be an influential factor as it relates to addressing challenged credits in the portfolio. Marks below book value can depress the BDC’s trading value as a percentage of its net asset value (NAV) – the book value of all investments in the vehicle. A public BDC that trades below NAV may be challenged to raise new equity to support future loans and grow assets under management (AUM), owing to the dilutive effect of the new equity on existing shareholders. Although most BDCs enjoy permanent capital, the ability to grow through new loan originations hinges on the ability to raise new capital.

Interestingly, most BDCs have adopted an organizational model that is different from a traditional bank. Whereas banks have distinct origination, underwriting/portfolio and workout functions, many alternative lenders, BDCs included, have adopted a “cradle-to-grave” model in which the same individual(s) are involved across the lifecycle of a credit. The same team assists in underwriting new transactions, monitoring the portfolio, and resolving credit challenges that would be delegated to the workout function at a bank.

The combination of these two factors — the pressure to manage public marks in order to sustain the ability to fund future loans, along with the cradle-to-grave model — creates a structure that can potentially be more flexible when it comes to managing credit resolution. As compared to a bank lender, BDCs are generally more likely to consider injecting additional capital into challenged situations. Although it can be distracting and can siphon resources from origination efforts, in some instances, BDCs have taken control of a borrower — either directly through a restructuring that results in majority ownership or through other mechanisms that allow for board control. The motivation is to manage through the credit challenge in a way that credibly maintains the public mark and defers a monetization until the position can be monetized at or close to book value.

Private Credit Funds

Whereas BDCs largely trace their lineage back to the 1980s, the proliferation of private credit funds has been more recent. Unlike traditional banks and public BDCs, private credit funds are rarely burdened by any public reporting. The market share captured by private credit funds represents the most opaque segment of the lending market, and default/distress within private credit fund portfolios is very difficult to detect.

The organizational structure of private credit funds is more variable. Some are structured similar to a bank, with distinct origination, underwriting/portfolio, and workout functions. Others employ a cradle-to-grave model. Notwithstanding the diversity of structure, a relatively consistent motivation among private credit funds, similar to BDCs, is the maintenance of AUM.   

Unlike BDCs, most private credit funds are not permanent capital vehicles. They are constrained by certain reinvestment periods and rights, and the return of invested capital outside fund reinvestment windows likely means a reduction in AUM. In a credit resolution situation, private credit funds are generally more flexible than either a bank or BDC. Often, private credit funds are affiliated with control-oriented private equity vehicles, leveraging common investment professionals, investors, resources and relationships. These attributes allow private credit funds to take control of a borrower in a way that most BDCs and banks cannot- although our experience suggests this is relatively rare given the impact on fund resources, particularly human capital, as well as the liability assumed from the equity position.

Impact on the Next Credit Cycle

When the next restructuring cycle arrives, whenever that may be, it will be met by a lending ecosystem that is significantly different than during the global financial crisis.   

The recent risk migration means that the majority of the issues are likely to be concentrated with the alternative lenders. At first blush, the result seems to be a market share shift in favor of traditional banks owing to a shift in the underlying liquidity of traditional banks as compared to alternative lenders. As banks look to resolve challenged credits within their portfolio, the refinancing or secondary sale of a debt position to an alternative lender is likely to be more challenging given that the alternative lender sphere will be dealing with problem credits of their own, and will be less interested in absorbing more troubled credits.

Without the alternative lender relief valves, banks will resort to traditional approaches to workout — rehabilitation or monetization through a sale of the company. In the event of a sale of the company, the post-sale financing will be more likely to be provided by a traditional bank lender, again owing to the relative liquidity position of bank lenders. Credit resolution situations in alternative-lender portfolios will also be more likely to result in a change of control and (for the same reasons cited above) the post-sale financing will be increasingly likely to be provided by traditional bank lenders rather than alternative lenders.

A deeper analysis of the impact of the next cycle casts some doubt, however, that bank lenders are set to regain market share. In recent years, another interesting trend has emerged, which could serve to couple the fate of credit funds and banks — banks have made loans to alternative lenders at the portfolio level. If the next credit cycle is significant, these loans may serve as a conduit for distress for alternative lenders looking to their way into the traditional bank market as well. The result will be an across-the-board reduction in liquidity, akin in many ways to the global financial crisis.

While the exact magnitude of the evolutionary correction in the lending universe is difficult to predict, it is safe to assume that we will see some level of restored ecological balance in the next credit cycle.


Joseph Weissglass
Partner | Configure Partners, LLC
Joseph Weissglass joined Configure Partners from the Middle Market Special Situations practice at Guggenheim Securities, where he was a Vice President. Prior to joining Guggenheim, he was part of the Global Finance and Restructuring Group at Barclays Capital in New York.

Weissglass has focused his career on providing advisory services to middle-market companies as it relates to financings, mergers and acquisitions, and restructurings. Weissglass graduated with a B.S. in Construction Science and Management from Clemson University and hold a MBA from the University of North Carolina Kenan-Flagler Business School. He is a FINRA General Securities Representative (Series 63, 79), and holds the Certified Insolvency and Restructuring Advisor (CIRA) and the Certification in Distressed Business Valuation (CDBV) designations.

Recently, Weissglass was recognized by the M&A Advisor as a recipient of the 2017 Emerging Leaders Award.
Comments From Our Members

You must be an ABL Advisor member to post comments. Login or Join Now.