Downturns and Private Debt

For those that survived the Global Financial Crisis (GFC) in 2007 and 2008, the aftershock seemed inevitable – and indeed it was. The capital invested into the middle market by Private Equity firms is exemplary. In 2007 there were 6,374 private equity M&A deals closed, representing $650.9MM of invested capital at an average Debt to EBITDA multiple of 6.86x^[1]. It wasn’t until 2014 - a full seven years later - that a similar amount of capital was invested into this market. But that was only the beginning of what turned out to be unprecedented growth in investment into this market.

Many recall industry experts, in the years between 2008 and 2010, commenting on the immense amount of money that was put to work funding middle market PE M&A pre-GFC. Many thought that there would never again be a time where so much money was deployed at “crazy multiples” with minimal structure or covenant-lite. However, by 2021 there were 9,446 M&A deals closed, representing a total of $1.1T of invested capital. More surprising was the fact that these deals averaged an 11.23x Debt to EBTIDA multiple. Even the “COVID-effect” couldn’t slow deals down as invested capital in 2020 marginally surpassed levels seen in the pre- GFC market of 2007.

Given the upheaval in the regulated banking market during and after the GFC, one might wonder how the M&A market expanded so rapidly in the years since 2009. A look into the private lending market provides some insight. Since 2007, the amount of dollars flowing into the private lending market has almost doubled annually. In the five years between 2003 and 2007, approximately $1.7T of capital entered the private lending market. In contrast, during the five-year period between 2017 and 2021, $5.3T entered the same market. That growth spurred new lenders, deeper pockets, more competition, and a multitude of new deals.

An examination of funding sources, as they relate to North American private equity middle market deal count, is of particular note. Between 2017 and 2021, institutional lenders made a total of 1,010 loans in this market, whereas private lenders extended a total of 2,514 loans^[2]. On a deal count basis, private lending sources provided nearly 70% of the total loans by deal count to the North American private equity middle market. In short, the rise of private lending far surpassed the growth of syndicated debt deals during the period.

In terms of deal structure, the rise of private lending markets has had a tremendous impact. Competition has become fierce among all types of banks – with debt pricing falling to, and remaining at, historically low levels. Structure has been quick to follow with covenant-lite deals and more highly levered transactions, exacerbated by persistently low interest rates causing company enterprise values to skyrocket. Loans made during this period were inherently riskier and therefore harder to monitor and manage. This is especially notable in a private lending construct which may not be equipped to monitor and actively manage troubled deals, and may be even more pronounced for private lenders. Many private lenders were formed post-GFC and therefore do not have fully established workout departments.

In the restructuring world it is commonly said that “a loan has never been made that could not be put into default.”  Lenders know that covenants are early warning signals of problems within a company.  A covenant default provides lenders a chance to come to the table with borrowers to understand if the company is on the right trajectory and, if not, what paths are available to course-correct. In a covenant-lite deal, there may not be an early warning signal, which means that a default may not be called until there is a payment default. In these cases, loan officers may only become aware of severe issues to a borrower just days or even hours before the situation reaches a catastrophic level. CR3 Partners once had a lender request the deployment of professionals for a brief engagement to understand issues within a borrower that was poised to bounce payroll within a week. More advanced notice would have provided more options. When this was communicated with the lender, the lender indicated more time was never an option – the lender had just learned of the situation hours earlier. If only the deal had been structured to allow for more early warning signals, such an urgent and severe situation could have been avoided.  

Many are wondering whether the rise in private lending will cause the anticipated recession to be different than those prior. Most economists believe there will be a recession in the near-term. One indicator is the persistent inversion of the U.S. Treasury yield-curve, which has been continuously inverted since July 2022. In fact, the inversion has achieved its largest negative gap between the 10- and 2-year curves since 1981, which was the start of a recession that pushed the unemployment rate even higher than it would have reached during the 2008 financial crisis^[3]. Jerome Powell was recently quoted as saying “While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses…these are the unfortunate costs of reducing inflation.” Many sectors of the U.S. economy are already suffering from inflation and high interest rates including housing, builders, and capital goods providers.  If there is a major recession, and 70% of the loans are with private lenders, one has to wonder what will happen to all of these loans.

During the financial crisis, the U.S. government stepped in to rescue banks with a variety of programs. The Emergency Economic Stabilization Act of 2008 created the TARP, which funneled approximately $236B to the syndicated banks and that was followed by TALF; the Federal Reserve Bank of New York (FRBNY) lent up to $200 billion on a non-recourse basis to holders of certain AAA-rated ABS backed by newly and recently originated consumer and small business loans. During COVID, the U.S. government created the Paycheck Protection Program, which allowed small and middle market borrowers to borrow fully forgivable cash to shore up balance sheets and keep employees paid during the shut-down^[4]. Further, the CARES Act provided flexibility for regulated lenders to collaborate with borrowers experiencing distress during the crisis, which in many cases eliminated a key driver for extreme actions in workout situations.

Unless there is some type of stimulus or relief for private lenders, these lenders will need a different approach to workouts than in previous situations. In 2008 and prior recessions, most borrowers would be forced to hire a Chief Restructuring Officer and investment bank to facilitate a recapitalization or sale of the company either in or out of court. Once complete, banks would move on, hoping to have recovered more than the amount remaining on the loan after considering reserves. Regulated institutions preferred this approach to “taking the keys” due to regulatory issues with this action. However, private lenders do not have this consideration. In fact, based upon their structure, in most cases private equity would prefer to protect their investment rather sell the company at a loss or endure an expensive court process.

However, private lenders are not typically designed, or interested, in a loan-to-own strategy. So as a result, these “accidental owners” are inclined to find a path forward to profitability. Rarely is an investment a total wash, so the key for private lenders will be to put its borrowers in a position to capitalize on its strength. Private lenders have the ability to take different positions in the capital structure, which is a luxury many regulated institutions may not have. This affords private lenders the chance to insert wedge capital which provides both a force for change and a source of equity for the turnaround. The private lender can then take control of the board without completely depleting existing equity, negating the need for an expensive bankruptcy filing to cleanse the balance sheet. The bottom line is that private lenders have many more tools in their toolbelts to find a path forward for distressed borrowers, and creativity will be the name of the game for the next recession.

About CR3 Partners, LLC

CR3 Partners, LLC is a national turnaround and performance improvement firm that assists, guides, and collaborates with management teams and their constituents facing any sort of transition, opportunity, stress, or distress. William Snyder is a Partner based in CR3 Partners’ Dallas office. Eileen Frino is a Director based in the New York office. Edwin Clark is a Manager based in the Dallas office. Kenny Greenstein is a Senior Associate based in the New York office.

[1] Pitchbook.com
[2] Excludes secondaries, funds of funds, and co-investment vehicles to avoid double counting of capital raised.
[3] Wall Street Journal
[4] Middle market defined as under $1BN in lending exposure. Note that institutional lenders do not account for more deals until lending exposure exceeds $2.5BN.