Following a decade of maintaining ultra low interest rates, central banks are issuing warnings about growing risks in corporate credit markets, where most investors have been forced to seek yield. Diminished margins of safety are already observable in the syndicated leveraged loan market and though less easy to observe, in directly originated loans. As the credit cycle progresses, we think many over-leveraged capital structures will be exposed in coming years and specialists will be needed who can recapitalize companies experiencing stress or distress. Although PIMCO is cautious overall on credit exposure, we see opportunities that may arise and that investors can take advantage of. However, changes in market structure are likely to make the task of investing in these situations different from prior cycles.
Rapid growth in non-financial corporate lending
On almost every metric, the volume of credit extended to companies is close to all-time highs. The stock of investment and sub-investment grade debt in both the U.S. and Europe is at record levels, while capital deployed in private loans by direct-lending funds and business development companies (BDCs) has reached new peaks.1 The Bank for International Settlements calculates that non- financial corporate debt, including both bank and non-bank lending as shown in Figure 1, is higher than during the depths of the global financial crisis (GFC), when U.S. GDP had slumped but the proportion of debt outstanding had not.2
Low interest rates and a favorable environment for borrowing have encouraged companies to issue a record volume of debt. Servicing that stock of corporate debt requires earnings, but with the U.S. economy synching lower with the global economy recently and PIMCO anticipating a continued “window of weakness” aggregate earnings may disappoint. An earnings recession, even without tipping into a full economic recession, would expose over-leveraged balance sheets. Were lenders to become more fearful or just less generous, the volume of corporate debt that may need restructuring could be unprecedented.
There are plenty of other possible drivers of corporate distress, including disruptive industry, trade, and technological forces and idiosyncratic company-specific factors. But the scope to make opportunistic investments will be significantly impacted by the changes that have occurred in the market structure of credit provision since the GFC.
The higher-quality end of the corporate credit market is not as high quality as it used to be. While the U.S. investment grade credit market has swelled from $2.3 trillion in 2008 to $6.1 trillion by the end of 2018, the proportion assigned BBB/Baa ratings has gone from nearly one-third to nearly one-half.3 In part, that is a function of financials having been downgraded. But it has also, in part, been driven by the low cost of debt making increased balance sheet leverage a more attractive means to drive return-on-equity. Some issuers are now beginning to behave in a more creditor-friendly fashion (de-leveraging), chastened by notable downgrades, but for others, synergies from debt-fuelled mergers and acquisitions may fail to materialize or earnings may stumble. When these large companies do occasionally stumble, their complex capital structures offer weak structural protections for creditors, and surprisingly few credit managers research these large issuers thoroughly. Despite these challenges, the quality of their underlying assets could present compelling stressed opportunities.
For the lower-quality end of the corporate credit market, the GFC accelerated the secular trend of bank disintermediation, with non-banks assuming an ever-greater share of sub-investment grade credit risk, either directly or via capital market syndication. Banks retain far less of the debt they syndicate today, and their capacity for market-making activity has shrunk too. Dealer inventories have declined 92% in the U.S. high yield bond market since the GFC,4 while many loans are traded in sizes such that a $1 million−$2 million transaction can move the price. The reality of a swollen leveraged finance market, coupled with shrunken liquidity provision, has yet to be tested in a bearish environment. A key characteristic of middle-market companies is that they are a prime hunting ground for private equity sponsors seeking to deploy their record $1.2 trillion of raised but not-yet-invested “dry powder.”5 Middle-market companies, which are often defined as those with less than $50 million of earnings before interest, tax, depreciation, and amortization (EBITDA), are typically less diversified and institutionalized businesses, making them more susceptible to earnings volatility.
The trend of bank disintermediation and the growth of non-bank lending to middle-market companies accelerated dramatically after the GFC. Part of this growth stems from sponsors taking advantage of benevolent debt provision to put more leverage on the companies they acquire. That includes asset-light companies in the technology, media, and business services sectors, backed by cash flows rather than hard asset collateral. Such situations could result in more severe losses than investors in first-lien loans are used to. In the more visible syndicated loan market, some recently distressed loans are now trading at 10 cents−20 cents in the dollar of face value.
In many ways, central banks and regulators have largely achieved their goal of dispersing more risky forms of lending among holders not considered to be systemically important financial institutions (SIFIs). However, while the banks may have ceded loan market share, most notably in the middle market, they have assumed a new role as providers of leverage to direct-lending funds and BDC portfolios. Despite taking risk at a higher implied level in the capital structure, if a far greater dispersion of recoveries (to the downside) materializes, they may still prove to be pro-cyclical in their risk appetite.
What are the implications of these changes in market structure?
In the post-GFC era, corporate middle-market lending has been the core focus of capital formation in private credit. In the U.S. the consolidation of regional banks has accelerated, while the exit of GE Capital from corporate lending (at least in part to avoid being designated a SIFI), allowed direct-lending funds, BDCs and more recently, middle-market collateralized loan obligations (CLOs) to aggressively fill the void. As institutional investors embraced direct lending as a familiar form of exposure offering higher absolute yields, the number and scale of lenders have increased dramatically. And, with increased competition, lenders seeking to deploy capital have granted higher leverage to middle-market companies.
Prior to the GFC, large leveraged buyouts represented the most aggressive use of leverage. This debt was primarily intended for syndication, though banks almost inevitably ended up with exposure, which led to the introduction of the Leveraged Lending Guidelines in 2013. They guided banks to limit the ratio of pro-forma debt to EBITDA to 6x.
Figure 2 shows record average levels of pro-forma leverage in U.S. syndicated loan financings, with loans to smaller, middle-market borrowers now employing higher debt to EBITDA ratios than larger borrowers, a reversal of the relationship evident at the 2007 peak.
These average debt multiples are based on pro-forma EBITDA provided by the sponsor, but the prevalence of EBITDA adjustments in recent years (EBITDA adjusted up, leverage ratio adjusted down), has obscured the picture from a creditor’s perspective. Once these supposedly one-off items are excluded or unadjusted, it is not uncommon to see leverage ratios materially higher than pro-forma. Figure 3 shows that more than 40% of leveraged financings are subject to adjustments, with the average adjustment reaching 0.65x debt to EBITDA in the first half of 2019.
Conservative creditors often reverse adjustments to pro-forma EBITDA because the assumptions underpinning them, such as various synergies and non-recurring items added back, often prove to be overly optimistic. A recent S&P analysis found that for deals originated in 2016, actual net leverage was 2.5x higher by 2018, on a median basis, than the level marketed to lenders. As a result, pro-forma debt-to-EBITDA of 5x−6x can often translate into actual debt-to-unadjusted EBITDA of 7x−8x. That is a multiple of earnings that sponsors have more typically paid to actually acquire middle-market companies in more conservative periods. Lending at these multiples can therefore be viewed as akin to lending at 100% of enterprise values typical of more conservative periods. This is reminiscent of real estate loans made before the GFC at close to 100% loan-to-value ratios, based on adjusted net operating income.
Anecdotally, we observed that a prospective U.S. borrower recently sought to extrapolate their pro-forma EBITDA from only the last three months, which included some highly favorable seasonal effects. In another situation we found in Europe, a sponsor adjusted EBITDA by using a forecast for the next 12 months rather than the last 12 months. The forecast anticipates a near doubling of EBTIDA, hence the debt-to-unadjusted (last 12 months) EBITDA was close to 10x. While the new sponsor might execute its plan and the company might grow into its multiple, the new lender will not participate in that upside and has far less margin for safety.
These middle-market leverage levels are untested over a credit cycle, but if these businesses and their balance sheets do need to be restructured, investors will generally be far less familiar with them and their underlying assets than with larger leveraged loan issuers. Some of today’s best known distressed investment specialists made their reputations acquiring and restructuring loans made to little known middle-market companies by regional banks in the 1990s and 2000s. They faced less competition and benefited from the ease of obtaining positions of control where there was a single existing lender or a small club of lenders. However, many of those specialists have now raised funds so large that they have naturally gravitated to the larger company universe, where they can deploy more capital. As a result, the middle market may prove to be a relatively inefficient and uncrowded investment universe if restructuring opportunities arise.
Currently some 80%−90% of syndicated leveraged loans are “covenant-lite,” or lacking a full set of covenants, including an unprecedented proportion of middle-market loans.6 Why then might a borrower go to a direct-lending fund or to a BDC? Borrowers certainly value a single lender relationship and it can save time and expense compared to a bank roadshow. But ultimately, the leverage available, its cost, and flexibility remain paramount. And the devil is in the detail.
Most loans do possess a leverage covenant, but more aggressive use of covenant headroom and exception “baskets” have eroded the efficacy of this covenant in protecting borrowers. One prevalent example is adjustments for synergies each time a sponsor bolts on an acquisition to the original business that issued the debt. When a bank negotiates covenants on behalf of a syndicate, they will typically require the CFO of the business to sign off on any adjustment greater than 5% and an audit firm to sign off on any adjustment greater than 10%. Direct lenders and BDCs that hold the whole loan themselves are not obliged to require equivalent sign-offs and can hence offer the borrower greater ongoing flexibility. For sponsors that need to execute a business plan to drive their equity returns, this is a material consideration and can help the lender win the loan.
Another example is switching to measuring covenants only on an incurrence basis, i.e., only upon the occurrence of a certain action of the borrower, rather than the borrower having to maintain them at all times. The lender may be able to state that they have covenants, but generous headroom and/or the incurrence basis impair their value in terms of acting as triggers to force management teams to the negotiating table. As such, they potentially allow financial performance to deteriorate further before the lender becomes aware and has a chance to take action.
High leverage combined with weak covenants threaten to increase the severity of losses on senior debt and the dispersion of recoveries when compared to prior cycles. It is particularly true given that nearly three quarters of capital structures with syndicated loans now have no subordinated debt to absorb losses.7 Private lending, meanwhile, is dominated by unitranche loans that similarly blend what historically would have been senior and junior or mezzanine debt into a single loan. In prior cycles, distressed-focused hedge funds and private equity funds frequently bought into subordinated debt that was more often deemed to be the fulcrum in the capital structure, and led the restructuring process from that position. If there is no subordinated debt, senior debt holders are far more likely to have to participate,
if not lead, restructurings than in prior cycles.
But should the senior lenders prefer to leave restructuring to others, their freedom to transfer or reassign loans has also been curtailed. Loan documentation today frequently embeds restrictions on the ability to transfer, with sales to specified firms deemed likely to be aggressive in a restructuring widely prohibited via “black lists” in the U.S. or their corollary “white lists” in Europe.
The holders of today’s stretched senior debt are primarily arbitrage CLOs, direct-lending funds and BDCs. All are essentially closed-ended in nature, making them stronger holders than the mark-to-market CLOs, hedge funds, and bank trading desks that were significant holders before the GFC and had to contend with margin calls and redemptions. Today’s holders do, however, face their own inflexibilities, which limit their suitability for participating in restructurings.
CLOs. With loan-only capital structures predominant, CLO collateral managers will almost unavoidably find themselves involved in restructurings. But these vehicles rely on cash flow arbitrage between the loans they hold and the notes they issue. As a consequence, they have limited scope to participate in debt-for-equity swaps as part of restructurings, since private equity typically offers no cash flow (dividends). If downgrades cause CLOs to exceed their typical 7.5% limit for CCC rated debt, they are now required to mark those loans to the lower of ratings-implied recovery or market price. This will make CLOs susceptible to the risk aversion of either the rating agencies or market participants. In a more bearish environment, they may seek to sell before lower marks trigger the “turbo” amortization of the senior tranches of the CLO and the switching off of fees on the subordinate tranches.
Direct-lending funds and BDCs. These holders are not generally concerned with ratings on the privately originated loans they hold. However, they do typically use funding lines from banks to leverage their loan portfolios. When those loans become non-performing, they also become ineligible for the borrowing base of those funding lines, diluting portfolio yields and the ability to pay the high income distributions that most of these vehicles offer. In Europe, “unlevered” direct-lending funds are more common, though the practice of originating unitranche loans and subsequently selling a super-senior first-out participation, usually to a bank, is similar in substance and effect to a funding line. It would be ironic if the direct-lending funds that disintermediated the banks and hold those loans in private-equity-style funds are forced to seek liquidity due to risk officers at the banks getting nervous.
SMAs. Many managers of direct-lending funds have also offered clients exposure via separately managed accounts. As a result, pension funds and insurance companies may find themselves tracking holdings through lengthy restructurings and potentially owning private equity in their fixed income allocations.
While none of these holders will necessarily be mechanically forced sellers, they may well prove to be motivated sellers. The commercial reality of reporting to clients about problem credits and dedicating resources to workouts for years to come will likely encourage many groups to take a loss and try to move on. Sales of private loans are already occurring, but are likely to proliferate over time and given a period of economic weakness.
For privately originated loans, for which there is typically a single holder or small club, sourcing liquidity is an exercise in price discovery, as prospective buyers familiarize themselves with the borrowing company, its assets, and operating performance. Rather than turning to dealers for liquidity, therefore, it is anticipated that many holders will seek to quietly transact bilaterally with groups they know can provide liquidity. Those transactions may involve sales of single loans, but could also involve transfers of risk across a basket or full portfolio of loans. The latter might take the form of refinancing bank facilities to effectively create a super-senior exposure to those loans, with scope to negotiate structural protections akin to those that feature in securitizations. Alternatively, it might take the form of actual sales of portfolios of loans. In either case, having sufficient bandwidth to analyze a number of special situation credits, especially middle-market credits, will limit the prospective buyer base.
In the past, the work-out departments of banks were typically understaffed during periods of elevated stress/distress. The non-bank lenders that now dominate middle-market lending are likely to face the same resourcing dilemma. The focus for years has been on sourcing and underwriting in order to deploy the capital raised, to switch on fees on invested capital, and to begin marketing the next fund. If losses are taken in these vehicles, revenues can decline sharply based on binary structural features, such as subordinate tranche collateral management fees in the case of CLOs, and preferred returns in the case of direct-lending funds. It is unlikely, at the point those revenues are threatened, that those groups will be in a position to hire the restructuring specialists they need.
The original lenders may state they will negotiate hard with borrowers, even those with which they have forged great relationships to source most of their deal flow. But those sponsors have weakened covenants precisely to preserve their negotiating power should their portfolio companies fail to achieve their business plans. It will be more important than ever for creditors to be prepared to be hands-on to defend their rights. This may involve proposing their own plans of reorganization through steering committees, being prepared to meet new money requirements, taking board seats and ultimately being prepared to take control of companies. The intensity of involvement creates a low limit on how many situations even an experienced professional can dedicate the requisite focus to.
Central banks and other official institutions are fulfilling their macroprudential role by sounding the alarm on lending standards in corporate credit. The preconditions for a material expansion in the volume of distressed debt are evident, whether the triggers prove to be idiosyncratic, disruptive, or cyclical in nature. For those with the requisite specialist resources and mandate flexibility, investment opportunities are expected to fall into three categories:
- Secondary distress – including fallen angels and larger buyouts, where financing engineering has increased vulnerability to earnings volatility and complex restructurings are required
- Middle-market recapitalizations – seeking to return companies to a sustainable path, either through restructuring debt or through a more holistic capital solution
- Portfolio transactions – providing liquidity to weak holders, through a combination of bottom-up credit analysis and structuring techniques
A combination of price discovery, complexity, and resource intensity creates a high barrier to entry for most asset managers, but should not deter investors seeking to deploy capital at lower implied valuations and with greater negotiating power. For those that are prepared, distress can signal opportunity.