COVID-19: An Orderly Repricing of Risk in Private Debt

By: John Czapla

The article in brief:

  • Capital markets experienced a rapid decline in valuations since late February, given the equally rapid proliferation of the novel coronavirus (COVID-19) pandemic.
  • The only comparable event to the spread of the virus for modern private capital markets is the Great Recession, but there are some key differences this time.
  • 2008 was more supply-side or financially driven, whereby public and private funds faced a liquidity crunch that led to a broader wave of forced selling and the Great Recession.
  • This downturn has been more demand-driven as many industries have been materially and directly impacted by the mandatory, government-imposed “shelter in place” orders and global shutdown to neutralize the spread of COVID-19. The environment has also affected investor sentiment negatively in all industries.
  • Through the quarter ended March 31, 2020, panic selling has been confined mainly to lower-volume public retail debt and equity sellers. These prices and trends may not be 1:1 indicative of pricing levels in the private markets.
  • In the private markets, deal activity has markedly slowed, and portfolio management has become the new focus.
  • New normal pricing and terms are in discovery mode, but all market participants agree that enterprise valuation multiples are lower, credit yield spreads are wider, and terms are tighter.

The New Investment Landscape

The impact of the coronavirus on financial markets has been breathtaking. Investor fear in the capital markets quickly went “viral,” which led to a rush for liquidity and retail fund-led widespread selling. This selling spree occurred first in the public equity markets and then the bond and loan markets. The last time we saw downside volatility of this magnitude in the public markets was the 2008/2009 Great Recession. The cause of the previous recession was a gradual breakdown of underwriting discipline and risk controls that led to the collapse of the financial system and liquidity. This time around, it has been an abrupt self-inflicted recession brought on by the COVID-19 pandemic and a government-mandated shutdown of all non-essential businesses to slow the spread of the novel coronavirus.

Businesses that assembled large amounts of people have been forced to shut down, and are now essentially earning close to zero revenues. Many of those businesses have reacted by laying off or furloughing large amounts of employees. These “highly impacted” industries are generally in the entertainment and leisure, retail sales, restaurant, education, air and train travel, and lodging industries. Any businesses peripherally related to these highly impacted industries have also been affected. Moreover, given the abrupt social and economic impacts of COVID-19, fear has contagiously impacted all industries to a degree, and notably, all capital markets.

High Yield (HY) Loan and Bond Market Trends: Material but Uneven Impact on Private Credit Markets

Public HY credit secondary trading markets—corporate bonds and syndicated bank loans—beginning in early March were brutally, and somewhat indiscriminately punished by the broad selling to fund the staggering $12 billion in investor redemptions. According to LCD, by March 23, HY loan and bond prices for performing credits plummeted from average prices near PAR to the mid- to upper-70s. In late March, secondary credit markets found their footing with B-rated credits broadly rebounding to the middle- to upper-80s on average. What has also emerged was a wide divergence of performance between credit ratings and industry segments with credits in safer industries or with higher ratings rebounding materially. Lower-rated credits, those with more COVID-19 risk, or in cyclical industries remained depressed.

Collateralized loan obligations (CLOs) and private credit funds are a vital part of the market, and while these players are not forced sellers, they don’t buy much in this environment. To make a trade, you need someone to take the other side, but a CLO is all about where a deal fits into its covenant tests, and private credit managers generally prefer to hold controlling blocks of loans versus smaller lots.

Notably, the large institutional credit managers that hold a vast majority of outstanding corporate loans, namely CLOs and private debt managers, have generally been on the sidelines. These trends exacerbate the technical characteristics of the loan markets. In essence, corporate loans simply are not traded in high volume, and there is not a two-way market, so it is susceptible to liquidity and credit events.

In this economic downturn, there will likely be a wave of loan downgrades to CCC, whereby CLOs will not be buyers of these low-rated securities. CLOs are typically allowed to hold up to 7.5 percent of loans with ratings of Caa1/CCC+ or lower, which makes mass credit downgrades problematic for CLO managers. When CCC-rated loans exceed CLO covenant testing limits, CLOs trip their over-collateralization (OC) tests, which means that the underlying loans may have to be marked down to market value rather than held at par or face value. The test measures the value of a fund’s assets compared to its debt and, if CLOs fail, interest proceeds are then redirected to repay debt investors, cash flow to equity investors are halted and a CLO can no longer buy lower-priced and lower-rated assets, hurting overall loan demand even further.

Private credit funds will be hesitant to purchase if the offered lot sizes are too small. Consequently, in down markets, given this seller/buyer imbalance, there is a material market-specific liquidity premium, which leads to implied levels below realistic fundamental values. Although, this time around, it seems there is more buy-side liquidity and demand, likely from distressed fund investors and select private credit funds with dry powder to step in and start buying at the bottom.

CLOs and private credit funds are a vital part of the market, and while these players are not forced sellers, they don't buy much in this environment.

Private Market Behaviors and Considerations

Private credit markets and the buy/hold nature of the fund structures, generally do not experience these trading pressures and price mainly on fundamental risk/return principles. In other words, there is a currently material liquidity premium built into the broadly syndicated credit market yields, which is not 1:1 transferable to the private credit markets.

Also, broader market loans generally have weaker documentation, minimal LIBOR floors, and higher leverage levels. Hence, it is dangerous to make broad, direct comparisons between broadly syndicated loan index levels and private loan valuations.

This is not to suggest that there hasn’t been a profound impact on private market valuations, or that broader market loan trends and yield indications are not useful. Valuations for private credits indeed have downward pressure on investment valuations given increased fundamental risks. However, trends are likely not as pronounced in private markets because money supply and demand are in better balance in the private markets. There is still plenty of competitive liquidity to satisfy an increase in loan demand to work out companies and to keep pricing in check. Also, valuations are more focused on estimated fundamental value and actual primary market pricing/valuation trends and indications.

Meanwhile, new deal activity has ground to a halt. Private equity and private credit managers quickly pivoted from a new deal focus in February to a portfolio management focus by March-end. Generally, new deal pricing, notably in the private markets, is the primary source of current credit pricing and terms for which to assess current existing fund portfolio valuations. Given the lack of new loan volume, new market deal pricing and terms are now not as widely available as benchmarks in the new post-COVID-19 economy.

A Closer Look at Private Credit Valuations

With dislocated secondary market pricing and little to no primary activity to assess current yields and terms, updating valuations for Q1 has not been this challenging since the Great Recession.

Primary Market Assessment

As part of its diligence for Q1, VRC surveyed nearly 50 market participants in the U.S. and Europe to assess fund level sentiment and inquire as to recent new deal terms, those recently completed, those in the works, or just new revised term sheets for current and future deal discussions. Those surveyed included private credit managers, banks, law firms, and market data providers. VRC’s transaction side of the house has also engaged in informal discussions with various private equity clients.

The broad consensus is: all deals are at more lender-friendly terms, including wider credit spreads with LIBOR floors, and stronger documentation.

In terms of pricing, the consensus is: credit spreads are 100 bps to 200 bps wider on average across the board for regular way deals. For the middle-market, these mandates would push 1st lien credit spreads into a range of 5 to 6 percent levels, 1st lien unitranche spreads from ~6.5 to 7.5 percent range, and junior capital all-in yields generally into the 11 to 14 percent zip code. Along with better credit spreads, deals may also include at least a 1.0 percent LIBOR floor and a pricing grid to increase pricing if EBITDA drops beyond base case expectations. In addition, documentation may be more lender friendly with tighter asset baskets and restrictions, tighter covenant cushions, better call protection, and fewer EBITDA add-backs.

Deal leverage is estimated to be down a full turn across the board to maintain requisite minimum 35 to 40 percent equity cushions and >2x cash interest coverage levels, driven by both lower enterprise and higher required risk premiums.

Industries with modest or high exposure to coronavirus disruptions will likely have wider spreads and tighter terms if they can attract capital at all. Overall, lenders are looking to reduce risk and increase the compensation for the risk that is underwritten given the high uncertainty around company and economic outlook.

Thus, for current valuations, these new market pricing matrix ranges will only be applied unadjusted to a smaller company set, which is generally performing, non-COVID-19 impacted, and non-cyclical companies. More severe adjustments will be required for underperforming and higher risk industries and companies.

Secondary Markets

Secondary market yields may not be a perfect price indicator for private credits, but broader pricing, yield trends, and differences in pricing amongst industries can be useful relative guideposts. The declining broader market loan pricing is indicative of higher required yield premiums required for non-investment grade corporate credits.

However, one should be careful to make a broad direct comparison of broader secondary loan indices to individual private loan valuations. At a minimum, one should examine relative industry yield levels and trends since the onset of the COVID-19 induced selloff as well as differences between industries to help guide relative differences. The charts included here show the divergent performance amongst industry groups.

Industries with modest or high exposure to coronavirus disruptions will likely have wider spreads and tighter terms if they can attract capital at all.

How to Adjust for COVID-19 Impacts and Risks?

All market participants, including portfolio companies and their private equity and private debt investors as well as valuation professionals, are segmenting industries and companies into low-, medium-, and highly impacted from COVID-19 restrictions. For highly impacted industries, owners are working to shore up liquidity by initially drawing down on revolver lines and delayed draw term loans before business performance turns.

Per LCD, over $225 billion has been drawdown from 360 borrowers since early March, mostly in the impacted consumer discretionary segments (i.e., leisure, restaurants, retail, etc.) It has been documented that both banks and private funds generally have the capital to meet the liquidity demands of their borrowers. Also, equity sponsors have started to infuse additional equity into portfolio companies, work with lending partners for temporary PIK interest, and work with portfolio company management teams to trim costs.

Unfortunately, given the timing of the market decline towards the quarter-end, most clients do not have revised forecasts as of yet, so most valuations will still be based on year-end financials. Risk adjustments are thus reflected as additional premiums to base “new market” credit spreads for debt valuations and adjustment to market approach multiples or DCF discount rates for private equity valuations.

In a few cases, we may be able to leverage downside recession cases in client investment memos as a proxy to help model scenarios to reprice the investment. These down cases are often based on experience gained during the Great Recession, which is a reasonable proxy to help assess COVID-19-related impacts to credit spreads, EV/equity valuation multiples, and equity costs of capital via estimated impacts to revenues and EBITDA. Also, for impacted industries, in line with industry trends noted above, the valuation analysis can conservatively consider the full draw up of available revolvers and consider any cash required to operate the business. The valuator needs to mind not to double count for the additional risks. That is, if revenues and EBITDA are directly adjusted downward in the valuation, then more normalized valuation multiples for the enterprise valuation and new normal regular credit spreads for the debt valuation should be applied.

However, the added complexity to specific company valuations must also consider the positive offsets:

  • Was the capital structure initially conservatively levered to withstand a large shock?
  • How much liquidity through cash and revolver availability does it have to weather negative cash flows?
  • The level of assistance from its capital providers, i.e., will private equity sponsors infuse capital and will lenders defer amortization and interest payments?
  • Expected levels of assistance from government programs (e.g., CARES in the U.S.), and the ability of the company to quickly reduce costs.

The above list references negatively impacted companies. Some companies and industries may hold up well and benefit in the current environment, such as telecommunications/broadband data providers, cable companies, e-tailers, healthcare, and anything related to delivered goods or services, such as a GrubHub or even UPS.

Wider Valuation Ranges

Though not a lot of paper is changing hands, the uncertainty is also leading to wider bid/ask spreads in broader loan market trades—as wide as 200 bps for many names from a norm of ~25 bps to 50 bps, which we believe wider value range indications is also true for private market valuations. There simply is more potential variability around valuation conclusions until all markets settle. These trends impact valuation ranges that we are providing to clients. Previously, to mimic syndicated markets, we would tend to provide a 50 bps yield range for less-liquid, privately negotiated obligations, whereas we are now employing yield ranges of around 100 bps for many credits.

For private equity valuation multiples, we are also generally considering wider ranges. For example, if we were using 8.5x to 9.0x, we may now be using 8.0x to 9.0x, prior to any adjustments for lower EV indications to capture higher volatility, and wider likely bid/ask ranges.

Where Do We Go from Here?

The current global macroeconomic outlook is still opaque. Only time will tell if the impacts from COVID-19 will be short- or long-lived, if economic damage is recoverable or permanent, and if we will experience a V-shaped (quick), U-shaped (midterm), or a Nike® Swoosh®-shaped (longer-dated) recovery.

Going forward, private investment valuations will incorporate updated fundamental and market data as it becomes available on a case-by-case basis. For those directly impacted by the COVID-19 shutdown, we will start to see a reported decline in revenues and EBITDA, and see more formal forecasts of liquidity and financial performance to use in future valuations. Ideally, we will have more primary market activity and valuation benchmarks. Either way, valuations will factor in the current environment and information available.

Only time will tell if we will experience a V-shaped, U-shaped, or Nike Swoosh-shaped recovery.

Some private capital market participants inform us that as they work to properly position or work out existing portfolio companies, they are also already viewing new targets in tiers of winners, likely survivors, and those “at-risk.” The winners and survivors are those with a target of nearer term buyout opportunities for private equity and lending opportunities for the private credit space. But for sure, that type of thinking is still on the back burner.

The pandemic has undoubtedly changed the near- and medium-term opportunity set in private credit and equity—for both better and worse. Lenders can expect better terms and new opportunities if traditional banks stay on the sidelines for a period, as they did after 2008. And those who invest in private equity can expect to pay lower multiples for a time.

On the other hand, we expect a prolonged period of wide bid/ask spreads and, thus, less activity in M&A and M&A related private debt financing. And of course, there will be continued pain and cash flow challenges in certain industries while the novel coronavirus remains a threat. There will be several defaults and credit downgrades for those impacted by COVID-19 and by the broader macroeconomic slowdown, which will likely officially manifest into a recession. Hence, some CLO’s will trip covenant tests and have cash flows shut off to managers and equity holders, and some funds will trip revolver mark-to-market covenants and need to square up. Most seemed positioned to weather the storm this time around so as not to spawn a wave of asset selling and a full, long-term freeze-up of markets.  However, if the spread of COVID-19 does not subside and markets do not unfreeze later in the year, as most expect, the situation could worsen.

Summary

All told, the impacts of the pandemic on the private credit markets feel much more rational and orderly than the impacts of the financial meltdown in 2008 that led to the Great Recession in 2009.

A lot of liquidity from market participants as well as from government intervention, it seems, goes a long way in keeping markets orderly.