In Private Debt, Beware the Seven-Times Levered Laundry Company

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(Bloomberg) -- Corporate debt’s biggest players have some public concerns about private credit.

For one Pacific Investment Management Co. money manager, fears that the market for private debt is running a touch too hot were exemplified by a company that launders hospital linen.

The would-be borrower, which Pimco global head of credit research Christian Stracke didn’t identify, sought a loan that would have boosted leverage to about seven times a metric of earnings even though the company’s growth prospects were scant. In a market where deals are scarce, some lenders are willing to accept those questionable metrics, Stracke said at the Milken Institute Global Conference.

Money has poured into a world of financial transactions known as private debt. Investors lend directly to borrowers, bypassing the capital markets usually to get higher yields than are available elsewhere.

Investcorp is looking to expand into private debt while BlackRock Inc. agreed to buy private credit manager Tennenbaum Capital Partners LLC in April. Demand for extra returns associated with less liquid debt will likely lift the market beyond $1 trillion in 2020, according to an estimate from the Alternative Investment Management Association.

‘Scary Development’

The surge is prompting warnings.

“The way the direct lending business is developing is somewhat scary right now,” Bob Kricheff, portfolio manager and global strategist at Shenkman Capital Management Inc., said at this week’s Milken conference in Beverly Hills, California. “If you have a moldy piece of meat and close the fridge door it’s still going to be bad -- you just don’t see it.”

Private credit covers lending to small and midsize firms that may otherwise struggle to get bank financing. It also includes loans to borrowers who may want to keep financial information confidential, since the deals don’t typically have to be registered with the U.S. Securities and Exchange Commission. The transactions are often more complex and can also include private securitizations in which collateral is bundled into bonds, as well as project finance and infrastructure lending.

While interest rates on the debt will generally be higher -- and subsequently a lure for lenders -- borrowers avoid SEC registration and ratings fees. Companies also benefit from flexible terms such as longer maturities, which is why large firms with investment-grade ratings may also choose this route.

Too Loose?

The market’s accelerating growth over the past decade is a product of tougher regulation that has reshaped the post-financial crisis landscape. That’s spurred traditional banks to cut back on business lending and created an opportunity for a growing group of asset managers. That growth has also helped address frustrations with low-yield investments, which is of particular importance to pension and insurance companies with longer-term liabilities.

Growth in the market has elicited warnings that deal terms are getting too loose. In a Carl Marks Advisors survey this year, lenders expressed concern about default rates on loans to small companies if economic conditions sour and interest rates rise.

$1 Trillion

“If there’s a place you have to be a bit careful about not not being differentiated enough, it’s that market,” A.J. Murphy, head of global capital markets for Bank of America, said at the Milken conference, referring to lending to smaller companies. Murphy is leaving the lender to join private-equity firm Silver Lake Partners in an investing role, people familiar with the matter said.

The AIMA, which estimated the private credit market will top $1 trillion by 2020 based on Preqin data, found smaller businesses are the largest borrowers, receiving more than 40 percent of lending that surpassed $600 billion at the end of 2016. Large corporates got almost 20 percent.

Lenders in the space often align themselves with a private equity firm, which uses the debt to buy out a company. That can at times lead to looser lending documents as private equity firms seek to ensure they deliver returns to investors while knowing lenders don’t want to miss out on deals.

“There’s been such demand in this space and so little supply, what’s happening is the direct lender that has to align themselves with a PE firm, they really aren’t able to fight back, to say, ‘I don’t want this deal,’” Shenkman’s Kricheff said. “I think there are these risks that are developing.”

‘Next Deleveraging’

Still, that doesn’t mean private credit is a byword for looser lending practices, the asset managers say. In the direct lending space, where investors make loans directly to smaller borrowers, deal origination tends to be done prudently, TCW Group Inc.’s Tad Rivelle said in an interview. Other areas may be better left alone, said Rivelle, the firm’s chief investment officer for fixed income.

“You could ask this question: Is this simply a more efficient way to underwrite loans, or a way for borrowers who are not bankable to secure financing?” Rivelle said. “That’s obviously what’s going to get resolved in the next deleveraging.”

Borrowers of so-called second-lien loans are increasingly getting the debt through private placements, according to data compiled by Bloomberg, as they’d typically struggle to get these loans through banks. So far this year, about $1.63 billion in such loans, which have subordinated claims on collateral used to secure them, will be privately placed. That compares with $2.15 billion for all of 2017, the data show. Privately placed second liens are placed before the first-lien loan is sold using the more typical, bank route.

MetLife, Brookfield

Among those boosting their private debt business is MetLife Inc., the insurer whose asset management division struck $11.2 billion in private placement deals last year, its most ever. Canadian insurer Sun Life Financial Inc.’s asset management arm is also planning to expand its private credit business through an acquisition. Credit Suisse Asset Management’s Private Fund Group set up a group for direct investments in April and Brookfield Asset Management Inc. bought a stake in alternative investment firm LCM Partners Ltd. in March.

“It’s such a big world and like any segment of the financial markets, there’s probably some interesting opportunities and good underwriting that’s being done,” Rivelle said. “But like all financial innovation, sometimes it’s not a question of bringing a more efficient process to the loan origination, but simply a mechanism to adversely select the lenders.”

The regulation that had kept banks from making loans that pile too much debt on companies is being dialed back under the Trump administration, paving the way for them to lend where they were reluctant to do so before.

That means the private credit world could see even more deal chasing. That said, there are still deals banks won’t touch.

Bank of America isn’t “looking to hold a bunch of seven times laundry sheet companies,” Murphy said at the conference.

©2018 Bloomberg L.P.

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