Have you seen lines between direct lending and the syndicated market blur, and how has that trend evolved?

RK: The rise of the availability of capital from direct lenders in both the US and European markets is a clear and obvious trend. Nevertheless, you can’t say, on that evidence alone, that the balance of power between private credit and syndicated markets has shifted. We are not operating in a vacuum, and therefore cannot disregard the broader macro-economic context.

Conversely, syndicated markets are, to a large extent, closed for business right now. With inflation sky high, the Federal Reserve and the Bank of England jacking up interest rates and geopolitical tensions in Ukraine, the private credit market is doing what it was designed to do – plugging the gap in debt capital left by traditional banks.

Recent deals Citrix and House of HR sported aggressive documentation. How is the syndicated market impacting docs for private credit lenders?

AD: There has always been a certain level of influence on private market terms, whether it be the gradual trickling down of flexibilities or sponsors taking advantage of competitive debt processes to push through terms inspired from the syndicated market. This year has proved to be very interesting as sponsors have been tapping the private markets to bridge the gap Richard mentioned, while expecting to achieve the same terms. Private credit clients who are less familiar with broadly syndicated market terms can be surprised by the flexibility being demanded of them.

In the end, the markets are fundamentally different, as private credit lenders hold the risk and need to ensure the terms are appropriate to protect their interests for the duration of that hold.  This, coupled with the balance of power in the current market as between sponsors and private credit lenders being repositioned in favour of private credit lenders who have the capital and are open for business, means that there’s currently a considerable amount of pushback on terms.

Which terms have your clients been pushing back on?

RK: They're focusing on pure economics, so pricing has gone up. We're seeing both the origination fees and the margin going up significantly, probably at around 50 bps for the former and 200 bps, the latter.

We’re also seeing tightening of financial covenant definitions, because that's what flows through everything. Gone are the days of pro forma EBITDA adjustments measured by a finger in the air.

I don't have a crystal ball to know when inflation is going to peak and the Federal Reserve pivots to cut interest rates. But this is an opportunity for lenders to try to pare back terms that they've given away in recent years.

AD: I’ve seen it with my clients as well, even on terms I was not sure we would successfully push back on. Sponsors have been conceding those points and have been giving covenants and tightening up financial definitions. This trend is here to stay, for now.

So could you say sponsor behaviour has changed?

RK: The whole team has had to change. The lawyers, the deal principals, the debt advisory function. When the market is receptive, their behaviour pushes terms. Often, when you speak to private equity clients about documentary loosening, they’re sometimes unfamiliar with the extent of the issue completely because their advisers just achieved it for them.

Advisers now are having to moderate their behaviour and reset to a different marketplace.

How likely is an imminent restructuring wave?

RK: Anecdotally, law firms, in particular, bulked up their restructuring ventures for the end of the cycle, but it never came. We had zombie corporations, propped up by seemingly endless liquidity afforded to the system.

It seems this time may be different. For the first time in decades, we've got interest rates at 3%, the dollar looks to be approaching parity. The system seems to be creaking.

How do you think the private credit industry is going to deal with a high default rate?

AD: Private credit operates through bilateral relationships where they hold the risk, and borrowers and deal principals work together closely throughout the life of the loan. If things get hairy, for many funds, unlike banks, there’s not necessarily going to be the internal infrastructure like a specialist restructuring desk to transfer the situation to and there is no liquid secondary market to easily offload to – the borrower and deal team will need to work through things together to address the challenges the business is facing. We saw the benefits of this type of relationship lending through the pandemic period.

But the challenges brought by the pandemic, which was more of a temporary dislocation, and the economic environment we are now facing are different. The private credit market is relatively young, and is facing its first fundamental macro challenge in terms of an inflationary and potentially stagnating global economy. It's hard to say how the private markets will respond to properly distressed borrowers in a potentially prolonged downturn. While there may be plenty of capital, the real question is how accommodating and supportive private debt can be in this environment.

How will recent weak documentation impact syndicated lenders in a serious restructuring wave?

RK: There could be a huge impact. The traditional levers that a lender would have to pull, such as the financial maintenance covenant, are not there. An early warning system to flash when the health of the business is deteriorating doesn’t exist. In a catastrophic failure you have to get in early.

Lenders are going to find it much harder than before because the traditional documentation to exercise control and the ability to offer bespoke restructurings and workouts are largely gone in the syndicated market. And the debt incurrence capacity (particularly once leverage is pro forma adjusted), coupled with the ability for borrowers to prime senior debt, is a real issue.

Why is the investor pushback we’re seeing now different from that seen during the pandemic?

RK: The pandemic was an example of a time of dislocation, because stimulus plans mainly supported the system. Private credit saw the opportunity to provide rescue financing, through hung LBOs and second liens. They provided capital to help fundamentally strong businesses along.

Some would call what we’re seeing in the market today a reset rather than a dislocation. Gone are the days of unlimited liquidity being pumped in from the central bankers. Gone are the days of monetary policy with 0% interest rates.

In a reset we see a reversion of that trend. The cramming of terms from the syndicated markets into the private credit markets clashes with far more sensitive underwriting and risk appetite in pricing, quantum and documentary terms. And we’re now seeing the balance of power as between Sponsors and private credit lenders shifting increasingly in favour of private credit on that, as discussed earlier.

Since King is in the name of your firm, do you have any thoughts on our new King Charles?

AD: Wish him well of course. Perhaps, given our firm’s name, it may be time to apply for a royal warrant.

RK: K&S has four former Queen’s Counsel in the London office, and of course, they’re now going to be known as King’s Counsel.