April 1, 2020

Breakingviews: Shadow lenders may get their day in the sun

by Breakingviews.

It may be the worst of times for shadow lenders. But for some, it could also be the best. Private debt – including direct lending, distressed debt and mezzanine financing – has exploded since 2010, with assets under management more than doubling to over $800 billion. The number of managers has also doubled in the past five years. The Covid-19 crisis will cause many to struggle, but firms with plenty of ready cash to deploy, like Blackstone’s GSO Capital Partners, Ares Management and Oaktree Capital Management, could hit payday.

The current virus-induced downturn is trial by fire for these less regulated shadow banks. Their customers normally have revenue way below $100 million, limited cash buffers, and lower profitability and higher leverage compared to often larger firms that get more traditional financing. These borrowers will probably struggle to meet basic working capital needs, which private lenders don’t normally finance, never mind their longer-term debt.

Losses could be stark. More and more shadow-bank money was chasing a limited set of sound borrowers over the past few years, so – as occurred more broadly in the years leading up to the 2008 financial crisis – lending standards often declined. Some funds accepted looser financial covenants, or protections, to secure deals.

Many though not all private credit funds restrict investors’ ability to redeem capital to avoid having to unload illiquid assets quickly or miss prime buying opportunities. This is an enormous benefit when their portfolios are likely to look pretty ugly. And because these private funds are sitting on over $270 billion of available capital, known as dry powder, they should be able to go bargain-hunting.

But the wealth isn’t evenly spread. For example, the biggest 10 funds pulled in 36% of new money in 2019, according to Preqin. So managers that didn’t secure long-term capital, spent too much on lousy deals, used too much leverage, or failed to keep aside ample cash could easily go belly up.

Over the past 20 years, median internal rates of return have spiked for funds launched in the years around crises. The massive infusion of central bank capital to the credit markets this time around could affect potential returns. But it is still likely to be a once-in-a-decade buying opportunity. It’s survival of the flushest.

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