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Private Credit 

Chris Haffenden

It’s a difficult time for asset allocators. The traditional rules for investing are failing them, with risk premia completely out of kilter with established norms. New asset classes are distorting comparative returns, as seemingly all the best deals are being done in private, with a premium paid for illiquidity (this is not a typo). 

Admittedly, sharp rises in rates in recent months have caused a lot of market dislocation, and it may be that the rules and premia return as markets stabilise. 

It is worth noting that we have had the biggest drawdown for bonds since the GFC which, after this week's events, has even surpassed the correction in Bitcoin. The traditional 60:40 (equity/bonds) strategies to mitigate volatility aren’t working either. Their negative correlation has completely reversed over the past 18-months, and are now at their highest positive correlation in two decades (see below).

Traditional thoughts on risk premia are being turned on their heads too, as witnessed by the equity risk premium (measured by the S&P 500 and 10-year UST yields) which is fast heading to zero. As mentioned last week, this could be a function of higher volatility in bonds with big losses for long-duration bonds. 

After this week’s pullback for risk assets, cash is the best performing yielding asset this year (EHY and US HY are around 4%). It’s the ultimate short-duration investment. It also yields more than the S&P 500. 

But for those who must invest in bonds, this excellent chart from Saxo Bank shows if you stay in short-dated govvies you can survive 150bps plus higher yields before you take any losses.

It gets even better if you go into two-year BBB-rated corporates in Europe, yielding 4-4.25%. We are hearing of CLO managers fishing in this space to park cash, and lower their lengthy WALs, which have been stretched by an endless number of A&Es. 

Younger fixed income managers haven’t experienced a market like this. For them long duration was the play; in a zero-interest rate environment you stretched for yield and sought to juice your performance over negatively yielding government bonds by going down the credit curve. 

Now, as we’ve said in these pages before, you need to be paid more to take risk in owning long-duration assets — via higher real yields for gov bonds and wider spreads for risk assets. With a negatively sloping curve, you can sit in the short-end and just earn your carry. 

TLDR: Nominal and real interest rates are now a headwind, rather than a tailwind. 

So, to avoid being whipsawed by the latest bout of rates volatility, it probably pays to sit in cash or safer short-dated assets until the yields top is confirmed. Rates are approaching their terminals, and while rates may be higher for longer — at some point it will pay to dip your toe into longer duration assets — after all a 50bps drop in 10-year UST yields gives you a healthy 8.35% return.

IMHO HY spreads are not reflecting the heightened risk, so why not pick IG (which is competing harder with cash and as such is offering decent spreads) to do all the heavy lifting? I would also suggest European Government bond yields have much more room to rise, therefore it may pay to be patient and wait for spreads to back up (as demand technicals worsen). 

But, I’m just a hack, what do the investors think? 

Luckily, we have the answer. BofA has just released its global fund manager survey, with a record percentage of respondents (31% net, highest in 20 years) thinking that long-term rates will be lower in the next 12 months. A net 24% of investors think monetary policy is too restrictive, the highest level since 2008.

Looking at Europe specifically, 73% think that European growth will weaken due to tight monetary policy, but only 30% see a hard landing. A very strong consensus, but as Mark Twain said:

“Whenever you find yourself on the side of the majority it is time to pause and reflect…..Do you know of a case where a consensus won a game?”

As Matt Levine opines this week, the theory that companies are worth more in public rather than being held privately has been debunked. Private markets are the new public markets, he says. 

He posits several possible answers for this: 

Public company stock prices reflect buyers and sellers (including short sellers) whereas in private markets the equity only trades when (and at the level) the company wants it to; 

Private investors want to pay for illiquidity (he says that it imposes discipline and avoids short term-ism, boosting returns — I’m less sure, more willing to agree to optimistic marks?); 

Public markets reduce value (compliance costs, short-term earnings focus, they systematically outperform — I agree with Howard Marks that much of this is rates/leverage driven). 

I would argue there is another, related to the first answer; a strong incentive for those invested to boost the mark-to-mark value, as it benefits all, especially when exits are unavailable. As we know for private equity sponsors and their LPs, it's all about preserving their optionality. 

The hype around private credit as a funding solution for everything from hung LBO debt to distressed CRE is growing to fever pitch. The headline return numbers, in terms of volatility-adjusted returns, are spectacular at 9.41% (2.74% above liquid credit) per year with no down year during 2010 to 2022. 

But as FTAlphaville reported this week, how much is this due to the marks? 

The Alphaville team point out the absurdity of the 1.73 average Sharpe Ratio (used to measure volatility adjusted returns) given minimal valuation volatility for illiquid private assets, despite having to post quarterly marks. Whereas the listed BDCs, which trade at a decent discount to NAV, are much more volatile and have a ratio of 0.38, much lower than leveraged loans and HY. 

The trader in me wants to find an arbitrage between the two, perhaps it's time to bulk buy BDC paper, gain control and push for the sale of PE fund assets to close the big gap to NAV?

But expanding on that train of thought might be for another column. 

As a natural sceptic, I’ve been looking closer into PE and private credit funding structures in recent weeks. My motivation is that the flexibility and availability of follow-on funding is a key determinant of whether deals will be forced into processes or if their runway can be extended, potentially forever. It is no longer as simple as looking at a fund vintage and existing commitments. 

We’ve come a long way from subscription lines — a revolving line of credit which uses LP commitments as collateral. To explain, these allow GPs to access cash, and smooth capital calls, without drawing from LPs committed capital. But while this made sense in short-term form (they used to be 30-90 days) some are now running for more than a year, which means that they can be used nefariously to distort rates of return. To elaborate, the calculation is based on cash flows generated, with capital calls seen as outflows and distributions as inflows. By using subscription lines in the calculations rather than committed capital it can inflate return figures.

GP-led secondaries were next up, used to unblock the illiquid private equity market and extend portfolio runway (which allows them to preserve their highly valued optionality), given they were starved of exits, with many PE funds coming to the end of their life. 

These transactions restructure one or more of the assets in the fund, while at the same time providing a liquidity option to LPs. In recent years, most of these have been done via continuation funds, where the sponsor-advised fund sells one or more of the portfolio companies to a newly formed fund, managed by the same sponsor. 

While there are many advantages to this strategy, there are a number of conflicts too, the most obvious being the incentive to transfer the asset at an inflated valuation, in order to collect more fees and carry, plus it raises governance issues, leading to calls for more checks and balances. 

In the US, the SEC recently imposed rules around GP-led deals, but this is being challenged by the industry, which is seeking a judicial review. 

But continuation funds are now seen by many as old hat, given the latest buzz is around NAV lending, with everyone including the private credit industry itself seeking to get onboard, as my private credit colleagues recently wrote. I would highly recommend Canary or the Gold Mine by Ted Seides as the best means of getting up to speed on NAV loans.

Some have raised the alarm. Among the canaries, is Anna Marshall at the Hewlett Foundation who has called them “an oxygen tank for GPs” implying that many were running out of air. 

At face value NAV loans don’t appear that toxic. Lenders issue senior paper at 12-14% with a 10-20% LTV against a portfolio of companies (still attractive, even if you haircut the inflated marks). The benefit for the sponsor is freeing-up capital to invest in portfolio companies (stressed or not) or distributing to LP investors. It also reduces the pressure on fundraising, proceeds can be used to add more deals to the existing fund, rather than going into the market to raise a new one. 

But as Seides notes, they introduce equity risk, and cross-collateralisation of debt —  conflating debt across the portfolio. It allows GPs to apply more leverage to portfolio companies than LPs might like. It can be viewed as an expensive dividend recap at the portfolio level, and a sceptic would say this juices returns and IRR, which is very useful in raising the next fund. 

The irony is that while LPs might not like this, as they are being primed, and their returns are diminished, they too are investing in funds which provide NAV loans! 

I agree with Seides that at a late stage of an economic cycle it's not a great time to seek to improve undercapitalised deals with more leverage. Given the fervour for NAV loans it's only a matter of time, when NAV loan margins fall and LTVs rise nearer to 50%. 

He believes that NAV loans resemble AAA tranches of subprime CDOs just before the GFC, adding: 

“Between portfolio company debt, NAV loans, and credit facilities, potentially three layers of leverage sit above private equity assets.”

We got spooked by CDO-squared deals, are we going to see LBO-cubed?

Private equity sponsors are struggling to find traditional ways to exit — IPOs are at their lowest level since 2008 — and Birkenstock wasn’t a shoe-in, likely to dampen investor sentiment further. 

A common theme over the past couple of years has been pulled IPOs, as lofty multiple expectations from sponsors failed to be realised. This has resulted in sponsors resorting to fund-for-fund transfers or dividend recaps as alternatives. 

But EQT thinks there could be another way, with its chief executive Christian Sinding telling the FT that it is looking to hold private stock sales, whereby shares in portfolio companies will be offered to its 1,100 LPs. 

Citing dysfunction in IPO markets, Sindling wants to hire an investment bank to build a book among EQTs existing investors for portfolio companies. Their LPs have the option of selling shares, holding them, or the chance to buy (either adding to their positions, or buying into companies held by other funds). 

Is it a better way to establish value? Potentially, as there is less motivation from the sponsor to inflate values (caveat being the quality and accuracy of materials and info released to potential buyers) as this is an exit, not a means to preserve sponsor optionality and generate more fees. 

Does this result in a better price? Possibly, as the LPs may have a better understanding of the portfolio company (and/or more optimistic after years of drinking the PE sponsor kool aid) and may demand less of a discount than an institutional investor.

But the biggest question, is what happens after the business is sold and the sponsor exits? 

The shares have been sold to a bunch of LPs, but how do they subsequently monetise their continued/newfound investment? 

Will the investment bank act as an intermediary and facilitate trades in the shares? 

What happens with governance, how do LPs exert influence?

If new money is required for the portfolio company, how can you herd numerous shareholders? 

It will be interesting to see if the kite being flown by EQT in the Financial Times will fly. But it's an intriguing idea, and worth exploring further. Let us know your thoughts. 

In April, I went in deep on Adler Group’s UK restructuring plan, which some practitioners believe resulted in an unfavourable outcome and could set a dangerous precedent. It is finally back in the Court of Appeal, starting Monday (23 October), and will be closely watched by market participants. 

So, this week, I revisited our copy, judgements and skeletons, with our latest hire Freddie Doust, a restructuring lawyer, ahead of the appeal by Adler Group 2029 bondholders. 

To recap, the German real estate group secured approval for its plan which saw €935m of new super senior money from a group of existing bondholders — to repay 2023 and 2024 maturities — with existing SUNs (of various maturities) ending up with varied and unequal outcomes. 

One of the main gripes for the 2029s was the lack of pari passu treatment. The company proposal was in effect a managed liquidation, and typically in an liquidation/administration, temporal seniority falls away and proceeds are distributed pro rata. 

The UK RP plan only comprised the SUNs. The key terms were (among other things): 

Extension to the maturity of the 2024 SUNs (also granted second ranking security) 

Remaining series (2025 SUNs, 2026 SUNs, 2027 SUNs and 2029 SUNs) had their maturities remain the same (and were granted third ranking security)

Inclusion of a loan-to-value covenant in the SUNs (and other documentary amendments)

Suspension to interest payments on SUNs for 24 months

In conjunction with the new super senior notes, this created a huge maturity wall in 2025, complained the 2029s, who said that the deal puts them at the back of the queue. 

To implement the deal, there were five creditor classes, one for each SUN maturity, with only the 2029s falling short of the 75% voting threshold. This meant that the court was asked to exercise its discretion to allow a cross class cramdown on the 2029s. 

The 2029s objected on a number of grounds. This includes the validity of the issuer substitution, claiming the English court didn’t have jurisdiction; they were not better off compared to the relevant alternative (liquidation); differential treatment of creditors and departure from the pari passu principle; and that shareholders were able to retain their equity (save 22.5% to the new money). 

We will know more on Monday on which aspects will form the basis for their appeal, but there are some clues from their initial application for permission to appeal which said:

That the Court erred in law and that it should refuse to sanction if a better plan is available

That the Court's application of the honest and intelligent man test was inappropriate in the context of a plan

That the plan wrongly departs from the pari passu principle

That there was no compelling reason to preserve the maturity dates under the plan

That the 'no worse off' test had not been satisfied

The company says the Court was correct in its initial findings. The appeal is tantamount to a request that the Court of Appeal provide an external framework for restructuring plans, it argues. The company's view on this point is it would be inappropriate given each plan is fact and case specific: the Court of Appeal isn’t there to produce a crib sheet for first instance judges.

Our expectation is that the departure from the pari passu principle and whether there is a higher bar compared to Schemes and CVAs (the honest and intelligent man) will be the key areas of focus. Challenging on the basis of valuation is likely to be harder — there is an excellent podcast in this regard by Osborne Clark — which is well worth a listen before Monday’s hearing. 

In Europe we are used to seeing forum shopping, finding a friendly jurisdiction (creditor or borrower) to implement a restructuring. In the US, they go shopping for courts, and in some cases for individual judges. 

In recent years there has been a move away from the Southern District of NY and Wilmington (Delaware) with Southern District of Texas taking a significant chunk of the action, and Judge David R. Jones presiding over the bulk of cases.

As my former colleague John Bringardner — now LevFin supremo at Ion, but also a veteran of Chapter 11 court reporting — said in a LinkedIn post this week:

“In the courtroom, he was unfailingly smart, thoughtful, and a stickler for rules. I remember when he halted an oil & gas case after a CEO on the stand admitted his insolvent company had an active leak from an offshore well in the Gulf of Mexico. Judge Jones called Austin on speaker phone from the courtroom to get the state's help sending someone to cap it immediately. Another day, my jaw dropped as he railed into a New York lawyer who had maligned opposing counsel in open court without evidence, dressing him down like a drill sergeant and effectively banning him from appearing in Texas again for a year.

But most of the time his hearings were a model of efficiency, spiced up with a dash of folksy banter and a clear understanding of how to restructure companies. It's what made him the busiest judge in the country…”

I have much less experience of Davy Jones, aside from the Serta Simmons uptiering case. In a blunt verbal summary judgment, he said that it was very easy for him to determine that the phrase [open market purchase] unambiguously (a dig at another NY judge) validated the uptiering transaction. As Petition amusingly note in its substack post , he divulged that he used the Merriam Webster dictionary to define what is a ‘purchase’ and what is a ‘open market.’

Jones was effectively saying that they were all big boys, and went into the deal with open eyes:

“The parties were keenly aware that the 2016 Credit Agreement was a “loose document” and understood the implications of that looseness. The objecting lenders acquired the majority of their loan holdings long after the original issuance and in anticipation of negotiating and executing a PET [Position Enhancing Transaction] to the exclusion of the PTL Lenders — exactly what they complain was done to them using the same provisions of the 2016 Credit Agreement. No evidence of an improper motive on behalf of either the Debtors or the PTL Lenders was presented. The Debtors always remained transparent in their goals. Likewise, the PTL Lenders acted defensively and in good faith…” 

But this case and many others could now come back under the spotlight as earlier this week he was forced to resign after he failed to disclose a live-in relationship with restructuring lawyer Elizabeth Freeman — whose firm Jackson Walker was involved in 16 legal cases heard by Jones between 2018 and 2022. 

One of these cases was McDermott International’s Chapter 11 in 2020, where the US energy services firm was taken over by creditors. It appears Jones’ relationship was revealed after court docs were filed against him by a former McDermott shareholder. 

Our professional interest, however, lies elsewhere as we have the McDermott cases in the UK and Netherlands to keep us busy. As we reported last week, it is seeking approval from courts in both England and the Netherlands to extend the maturities of its debt facilities and to effectively wipe out $1.7bn in arbitral awards and administrative fines against it. 

This week, we reported that a group of McDermott’s non-consenting lenders last week filed for the appointment of a restructuring expert in the Dutch court to evaluate the energy service firm’s Dutch Scheme (WHOA) which is running in parallel to the UK process. The company made its own filing to appoint a plan observer around the same time it filed its WHOA plan. 

However, a restructuring expert and observer cannot be in office simultaneously. And the appointment of a restructuring expert would create a “lag” in the case’s timeline and deprive the company of the power to draft its own plan. 

Another company going down the WHOA route is Dutch plastic container packager, Schoeller Allibert, where more detail was provided on its recapitalisation this week. Majority shareholder Brookfield will infuse €154m of equity, which alongside a new €125m five-year term loan from Brookfield and special sits fund SVP will be used to refinance its €250m SSNs due Nov-2024.

As 9fin previously reported, SVP had been buying the SSNs at a discount. Creditors holding about 70% of the company’s debt have signed binding documentation to support the recap and refinancing. This is above the two-thirds majority threshold required to cram down potential dissenters in a Dutch Scheme (WHOA), whom in this case may be the Schoeller family with a ~30% equity stake. 

Our review of the deal can be found here

Praesidiad has obtained approval to convene all its lenders as a single class, bar a sanctioned Russian bank, to vote on a restructuring deal to become the firm’s new owners. Sir Alastair Norris approved the perimeter security firm’s plans to convene a scheme meeting on 6 November. Ownership of the group will be transferred to a new HoldCo, with sponsor Carlyle bowing out and SFA lenders taking control according to the company’s skeleton argument.

Wiitur, the German elevator components producer avoided the spotlight of the English courts after securing 100% approval from its lenders to a restructuring plan, which sees all of its 240m second lien debt held by KKR equitised, while €390m of the group’s €545m first lien debt and €90m RCF will be reinstated pari passu at the OpCo level. The remaining €250m of first lien debt will be elevated to the HoldCo level, as reported. 

French fine foods firm Labeyrie is mulling various avenues to fatten up liquidity, reports 9fin’s Laura Thompson as its leverage bloats above the threshold for its RCF springing covenant. Results released this week show that senior secured net leverage is 8.5x, with total net leverage at 9.0x, on a roughly 50% YoY decline across Labeyrie’s reported EBITDA figures. 

As Bloomberg reporters revealed earlier this week, Aggregate Holdings may be set to lose yet another trophy real estate development in Berlin with senior and junior lenders holding debt against the Fuerst project battling it out in the Luxembourg courts. Senior lenders are willing to provide ‘substantial resource and capital’ to finish construction, said their spokesperson. 

As outlined above, most of my week was reading through Adler reports and documents, so a lot of content has been put on the reading list for this weekend.

It’s a big weekend for sport, with the rugby World Cup semis, the England cricket team is also playing South Africa in a must-win game, plus we see the return of the English Premier League. But there should be time to for the latest FT long read, whose title is pure clickbait: The fake hitman, the crypto king and a wild revenge plan gone bad

Sometimes Credit Analysts manage to nail it in their reports. Chapeau to BofA for this: 

Superman don’t need no seatbelt: we remain in 2020s = higher inflation & yields, lower returns; bond yields may go lower in ’24 but no secular bull market until Fed/govts stop playing Superman, put on their “seatbelts” & express need for lower deficits (reminded of tale of Mohammed Ali who is approached by flight attendant: “Mr. Ali, we’re about to take off, would you mind fastening your seatbelt.” Ali responds, “Superman don’t need no seatbelt,” to which the flight attendant responds “Superman don’t need no airplane”).

Unfortunately, Judge Jones may not get to hear J&J’s third attempt to file for bankruptcy to deal with $1.9bn of baby talc litigation claims. 

David’s Bridal bigs up its latest executive hire. H/T 9fin’s Dan Stone

Let’s hope these dreams are not just for restructuring lawyers, hoping for bankruptcy filing number three to arrive. 

It's a big week for Brighton and Hove Albion Football Club, playing away against Manchester City on Saturday (thanks Gareth for resting Dunky) and then home to Ajax in the Europa League next Thursday. And on Wednesday 1 November, at Brighton’s Caxton Arms, TheBrightonBard releases his book of BHAFC poems, Wins, Grins and Limbs.I’m aiming to be there.

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