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Private Credit 

Chris Haffenden

A fair amount has happened since the last Friday Workout on 22 December. Drunk on seasonal good cheer, the Everything Rally was in full-on party mode by year-end. But the first few trading days of this year, normally strong due to the January effect, are reflective of a drier January. 

That said, the moves in the past couple of months were nothing short of remarkable, and even after the latest minor pullback it leaves risk asset prices vulnerable and at risk of disappointment.

For example, what is the rationale for the iTraxx Crossover, the proxy for European high yield, to trade at such tight spreads, at just a low 3-handle? 

Most of last year the index was in a 375-475bps range (still underestimating credit risk in my view), but it closed on 29 December at 310bps (now at 345bps). 

I can’t detect a meaningful change in the outlook for EHY credit quality during Q4 to justify such a move. Yes, defaults were lower than feared in 2023, but does a more optimistic rates and inflation outlook justify such historically tight spreads? 

This chart from ING is illustrative (NB published in October, when spreads were 100bps+ wider!) 

Effectively, EHY spreads are now well below expected default rates — this has rarely happened in the past 20 years. Few observers expect defaults to fall markedly in 2024, most expect them to rise moderately. Plus the all-in cost of debt for HY corporates, is not far from the highest for over 10 years, despite the recent drop in yields, further supporting the argument that defaults should rise (and normalise after years of ZIRP and excess liquidity). 

And that is not all. Companies are not producing enough free cash flow to comfortably service their existing debt, let alone service refinanced paper that, despite the recent spread compression, should see their interest costs almost double.

But as our latest Top of the Flops report notes, the market doesn’t reflect this: the number of bond and/or loans issuers trading at stressed/distressed levels dropped markedly in 2023.

On 30 December 2022, 209 bonds from 135 borrowers were indicated at a STW of over 800bps (our definition of stressed/distressed). At the worst point in mid-July 2022, 318 bonds from 199 were marked as stressed/distressed, more than one-in-five (21.3%) of all EHY issues.

This percentage has dropped sharply since, to just 7.65% (one in 13) at end-2023 with 117 bonds from 78 issuers indicated at stressed/distressed. After a sorry 2022, European HY produced an impressive 12.1% return in 2023, with a 5.5% return in the fourth quarter alone.

Similar to EHY, the number of stressed/distressed loans has fallen substantially, more than halving by the end of 2023 to 99 loan tranches from 63 issuers. European leveraged loan performance outpaced bonds in 2023 with the ELLI producing a record-breaking 13.56% positive return, closing the year at 96.11. This followed the first negative return in a decade in 2022 (-3.15%). 

The benign backdrop for LevFin could lead to a number of stressed names taking advantage of a red hot financing market to find resolutions to their cap structures in the coming weeks. If I was a betting man, I wager Tullow; Boparan; Upfield Flora and Stonegate could chance their arms. 

Could we see the repeat of late 2020 and 2021 when a number of challenged borrowers were able to get deals away, as I remarked that even a dead cat could get refi’d? Remember, during that period as well as deals for Boparan (the first), we also had deals for Aston Martin, Pure Gym, Ideal Standard, Pizza Express, and Stonegate. A real mixed bag of subsequent performance, btw.

If a wave of stressed — by metrics, given many are not trading that way in secondary — refinancings occur, it will disappoint a number of restructuring advisors and special sits funds. 

But I’m sceptical this is a cure-all as there are many differences between then and now, which we will go into more detail in our 2024 European Distressed Preview, to land in the coming days. 

Some of the more interesting stats for 2023 lie in the sharp drop in M&A and IPO activity. 

It was the poorest year for M&A in a decade (17% YoY decline, with PE-backed deals -30%) and wasn’t great for IPOs either, as shown by EY data below:

This at first blush seems odd. After all, stock markets were firm for most of the year and most gains were from price/earnings multiples expansion, with plenty of dry powder for PE funds to deploy for LBOs, with private credit funds and CLOs desperate to lend (especially to new names). 

The main reason for the lack of activity appears to be the mismatch in valuation expectations between issuers (and sponsors) and investors/buyers. As EY notes, the flurry of large IPOs in September 2023 saw under-whelming aftermarket performance, causing others to delay deals.

So, why the big differences in valuation expectations and deal multiples from buyers and sellers?

First, lets look at the drivers for lower multiples, which is mostly rates driven. 

An increase in funding costs should reduce valuation multiples as it is more expensive to finance transactions, reducing returns. This also drives buyers to smaller deals in the middle-market which are typically higher growth (can deleverage faster, and are normally trading at lower multiples than large caps). Higher interest rates also affect discount rates, reducing DCF valuations, and lowering IRRs. And finally, higher debt funding costs reduce the amount of leverage sponsors can pile on acquisitions, leading to higher equity cheques and lower returns. 

So far, so leverage finance 101. But there are other factors at play, keeping multiples high.

In the past, the lack of IPOs and limited life of PE funds, would lead to sponsors being more flexible on exit multiples to trade buyers and other PE funds, especially if their roll-up and growth strategies had borne fruit, and/or if other portfolio companies had performed well. This also left something on the table for the next buyer. 

But nowadays, there are many more options for sponsors such as continuation funds and NAV lending, so there are fewer burning platforms. These options have the added value of greater flexibility and optionality for LPs and GPs, to stay, go, or cherry pick which portfolio companies they want exposure to, and even co-invest in the provision of new money. 

As I argued in a previous Workout this has led to “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.”

Delay-and-pray has been elevated from the company level to the fund level, with the added advantage of collecting more fees and carry. NAV lending can also add further leverage to portfolios and portfolio companies — a fund dividend recap of sorts — as Ted Seides wrote in Canary in the Coal Mine: 

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

So, the first prediction from your’s truly for 2024. I’m not as confident as most market observers for a big pick-up in LBO activity, or at least for larger deals, unless sponsors and direct lenders get more realistic on deal multiples. 

My gut feel is that spin-offs, carve-outs are more the order of play, as companies seek to deleverage and concentrate their business strategies. A good example is Vodafone’s exit from Spain and its keenness to find a solution to Italy, and Atos’s protracted demerger attempts. 

My view on IPOs is less clear. I think stock markets are frothy, which should attract interest in floats, but there is little premium between public and private valuations making it difficult to book gains, so supply-side economics may win out, and public offerings fail to ignite. This could mean that NAV lending and continuation vehicles remain the more attractive alternatives in 2024. 

But if the LevFin market maintains its strong bid, I can see a wave of dividend recaps in the first half of 2024 to allow sponsors to realise value. But is this the right point in the cycle to lever-up portfolio companies? 

As corporate top lines plateau and economic growth slows, with margins elevated historically, it is difficult to see a path to deleveraging via business performance. Sponsors are unable to juice their returns via piling on more cheap debt, which increases the reliance on multiple expansion and/or lower rates when the time comes to exit/refi. 

So, are we at the right starting point for multiples, or are they artificially inflated?

Could there be a double-whammy of higher than expected defaults leading to higher risk premia which in turn increases the cost of debt and lowers EV/EBITDA multiples? 

My gut says no, and possibly yes. In which case it's difficult to see double digit LevFin returns for a while. 

If I had a pound for every time I read/heard about the 'Golden Age of Private Credit', I would not be writing this, but would have already retired to the Sussex Downs to keep bees (not to farm Alpacas in Cornwall — as one fellow turnaround journo suggested I do at a recent K&E event — irked by all the glowing mentions of 9fin by his sources). 

The message peddled by the big beasts of direct lending is you are getting paid double digits, (typically 600bps at 5x leverage) for senior secured debt at low LTV — what is there not to like? 

Well, the first question to ask, is whether these companies can service this debt? 

Lenders are hoping that the big increase in IRR will compensate for the higher repayment risk as DSCRs fall. But, how clear is the route to deleveraging and exiting, especially if the macro environment remains tough, and rates don’t fall as fast as expected? 

And if you can’t afford the debt servicing costs, we, the friendly, always-by-your-side direct lender with bespoke solutions, have something to offer that the banks can’t. What about some PIK debt? 

But double-digit PIK debt is a huge drag on deleveraging, as all things being equal, you need to grow your business faster than the debt accrues. As a borrower this isn’t something that you should ever agree to lightly, and for a lender, it may reduce your options to call a default (no interest payments to miss), until a potential default at the back end which may be too late to fix. 

Whatever your views are on the risk/return profile for direct lending, the private credit gold rush is on, with record amounts of funds raised and plenty of opportunities being touted by direct lenders in their media interviews. 

But as for any market which grows so quickly (460% growth in the five years to end-2022), with huge amounts of funds raised and so far under-deployed there is a danger that capital is misallocated. 

There is going to be competition for a limited number of assets, which drives down pricing and some lenders will end up funding companies in sectors outside their areas of expertise. I would also argue that some of their former darling sectors such as healthcare and software have their own challenges and there is a fair amount of concentration risk. 

Many funds are populated with former LevFin bankers with great sponsor relationships, and yes, they may have done a pubs deal on the sell side and some pulp and paper EHY. But they didn’t have skin in the game and now they have to deal with the lumpy performance between issuance and maturity for Italian paper mills and hundreds of Slug and Lettuce’s. 

Private credit is now being touted as a cure for all ills — for example direct lenders are ready to pile into the carnage which is commercial real estate (see my colleagues Synne Johnsson and Peter Benson’s recent pieces) and step in, after incumbent banks reduce their exposure and head for the exits. Admittedly there are some funds such as KKR and Blackstone which have dedicated real estate arms and specialist knowledge, but others have much less expertise. Although I suspect there are plenty of real estate bankers out there looking for jobs. 

Direct lenders flout their flexibility and ability to provide capital solutions for troubled assets, with their credit opps funds standing by to offer non-cash pay HoldCo PIK debt to smooth a refinancing of underperforming assets (some even decide to participate in the equity too) neatly side-stepping some of the incurrence covenants, as it sits outside the restricted group. 

Many are also touting their ability to offer alternative non-cash flow based lending, such as ABLs. However, few have the systems and direct expertise akin to incumbent specialist asset-based lenders such as Wells Fargo. For the newbies it is more of a collateral LTV funding trade, rather than lending against varying levels of inventories, receivables and PPE. But that value of collateral changes over time, and the borrowing base should do the same too. 

I suspect, their real estate lending model is also mostly LTV focused. 

For all their purported advantages, the lines between BSL and direct lending are blurring, as banks seek to get back into the relationship lending game. Don’t mention the S-word, but club deals are really syndicates if lenders are in double figures, and as my colleague Josie Shillito wrote recently in Taking the Credit, many are selling-down their positions to smaller funds who are unable to get in at launch. 

And arguably LevFin debt is becoming more competitive. As the risk appetite increases and the gap in leverage being offered reduces, is 5x leverage really stretched senior? 

Is the reduced leverage offered for mid-market companies reflecting their new found caution, or a function of the reduction in multiples in the mid-market since the heady heights of 2021? 

As the Argos Index below shows, leverage in late 2023 was 2.5x turns lower than the peak in 2021. My back of the envelope calc is that 1-1.5x of reduced leverage maintains a similar LTV. 

Argos has an even scarier chart, showing the transaction outliers. In 2021, more than 25% of deals had multiples in excess of 15x, this came down to just 14% in Q3 23, whereas the portion of transactions at less than 7x multiple has doubled in a year.

The poor 2021 vintage (high leverage, high multiples) should flow through to more defaults in 2024, and we’ve noted in these pages before where the bulk of recent loan amendments lie. 

Marc Preiser, Portfolio Manager at Fidelity said in a recent private credit note: 

“I do expect to see some evidence of defaults starting to come through in the first quarter of 2024. A year of higher rates and elevated costs for issuers should begin to reveal how exposed people are. I don’t expect the market to crash, but we will see more trouble around the edges, with more deals slipping into distressed territory and a higher level of workouts across the asset class. We could also see more situations where keys will be handed back to lenders.”

“A worse-case scenario for the next three years would be a default rate close to 6% and recovery rate of 50%.” 

I suspect that a number of restructuring professionals would be very happy with those metrics if they were to materialise for direct lending and the wider LevFin market this year. 

An unwanted present landed on the Friday morning before Xmas for the 9fin team, with AnaCap Finance Europe’s restructuring plan. As many of you are aware, we had expected the NPL buyer and servicer to go into restructuring after questioning the sustainability of its business model. 

AFE is marketed as part of the carve-out of AnaCap’s credit business into Veld Capital, its central Assets Solutions platform. But in effect, its just a portfolio with a bunch of bonds issued against it and, as you can see from the screen-grab below, at an extremely large LTV.

AFE’s peers are structured differently, with many seeking to become more asset-lite and pivot towards servicing rather than being owners of assets, as they struggle to replenish NPL balances as their funding arbitrage erodes. Their funding costs have been severely impacted by high interest rates and a shift in market perception towards debt purchasers. The use of securitisation (for re-performing loans) is now a key strategy in raising funds competitively.

Back to AFE. With its extended RCF due end-December, the deal was revealed late, on 22 December. 

Peer Arrow Global, via an affiliate, is providing a €95.7m bridge loan to be repaid through a €132.9m super senior term loan facility paying 1% cash and 11.5% PIK. The €307.5m senior secured FRNs due August 2024 are being amended and restated to mature in July 2030 with a 250bps margin uplift to E+750bps and a revised 1% floor. €35.7m of additional SSNs are to be issued with the same terms as the restated notes, offered at a 70% par value discount to generate roughly €25m for general corporate purposes and working capital. The economic value will be divided 51:49 to Arrow and the bondholders, but Arrow will have 100% voting rights.

Our first take, is that the transaction is unlikely to fix the fundamental problems facing AFE in a high-rate environment. Its proposed post-transaction LTV of 82.3%, calculated as €420m of net debt over its €510m seven-year ERC, is too high, in our view.

Yesterday, AFE held a bondholder call to go through the deal (without Q&A). We are working on a more detailed deep dive on the deal in the coming days. And we are contacting the various stakeholders to pick apart their motivations and views on the economics. 

We can see the attraction for bondholders of Arrow coming in to service the portfolio (not an easy task, as a large portion (59%) is now real estate, requiring some investment), but in turn bondholders are being primed by the new debt. 

On face value the return for Arrow via the super senior loan isn’t that high in relation to the underlying portfolio, but it will also be paid 1.5% of NAV in annual servicing fees.

And is this a viable business, or just a portfolio to be wound down, and try and return as much of par to bondholders? 

Its aim is to replenish the NPL portfolio. However, is this realistic? Can the restructured business be competitive in its cost of capital in bidding for assets? We assume a significant benefit comes from Arrow’s servicing infrastructure and potentially from its lower cost of funds. 

In short, a lot to unpick. Our initial view is that AFE is idiosyncratic, and unlikely to be a template for dealing with the upcoming maturities for other debt purchasers. But we have learnt a lot about the sector in investigating AFE and this will hold us in good stead when/if its plans arrive.

Just before the break a couple of A&E’s for stressed loans snuck out, both with sponsor contributions, therefore we would consider them as soft restructurings. 

Flamingo Agriflora, the east-African flower producer has amended-and-extended its €280m TLB by 3.5-years to August 2028, with a €50m sponsor injection from Sun Capital reducing the loan balance to €236.5m. Margins are unchanged at E+575bps, but the ratchet was removed. 

Iberconsa, the troubled Spanish fisheries group, received a €72m equity injection from its sponsor Platinum Equity to pay down debt. Its €290m TLB was extended to December 2027, with a 75bps margin uplift and 1% PIK consent fee. This was enough to get an upgrade by S&P to B-. 

SBB, the Swedish real estate firm has postponed payments on its hybrid debt, to preserve liquidity. Our view is that the immediate impact is limited. Yes it does restrict dividends, but after the residential JV set-up and EduCo sale this shouldn’t cause issues elsewhere in the group. 

As expected, Signa Development, failed to avoid an insolvency filing, and is now under Austrian self-administration. Watch out for an explainer piece on the Austrian process in the coming days. 

Atos has given a non-update, update. It confirmed press leaks that its cybersecurity business is up for sale, with Airbus the front-runner to acquire. More talk about getting lenders to extend and refinance existing debt, and that more asset sales may be required if unable to do so. It is still negotiating amended terms with Daniel Kretinsky for the badCo, Tech Solutions. For those looking to get up to speed on the name, which we expect to be the next French special sit, our two part series in available here. 

Branicks (DIC Asset) is in a parlous state, with insufficient cash to meet maturities in April. In this excellent Financials QT, 9fin’s RE expert Hazik Siddiqui outlines the problems facing the German RE business which operates a rental portfolio alongside originating and managing RE funds. 

In putting together our 2024 preview (due soon) I have been looking through plenty of outlooks from investors and the sell side. One of the best, is Uncle Jim Leaviss from M&G, in his World of bonds special.

Sticking with M&G its global real estate outlook piece — Negotiating higher rates and other new paradigms — is a good overview of the challenges and opportunities for CRE and a must read for real estate private credit funds. 

As we try and get back into the swing of things, how do we avoid distractions? The author of Think Big has some good ideas — I particularly like the concept of theme days (for 1-1s, writing, research, etc.) I already block out Thursdays for writing, and will expand this further in 2024. 

One of the more interesting pieces of news was the New York Times lawsuit against Microsoft and OpenAI, alleging copyright infringement. The best piece of media on this was from the NYT itself, and I’m told that the complaint is very well constructed. One to watch. 

Elsewhere, one (I won’t name them) investment bank revised its 2024 US credit outlook in just the third working day of 2024!

As a former Jefferies employee, albeit a long-time ago, I was well aware of its close relationship with Leucadia. But until I read this note from Rich, I didn’t know the background and the personal affection between Rich Handler and Joe Steinberg. A reminder that people matter in this industry. 

And finally, some Brighton news. Despite not having 10 players fit to start against Spurs on 28 December, including no fit full backs and no wingers, we were 4-0 up after 76 minutes playing our best football of the season, relying on teenagers to fill the gap. 

Brighton’s teenagers scored 19 goals in 2023, more than the rest of the Premier League clubs combined! And our chairman and lifelong fan Tony Bloom was awarded an MBE. 

My son, and football journalist Charlie Haffenden, sums up Brighton’s year the best:

And I was up with the gods in the London Stadium on Tuesday (should have brought my binoculars), when we secured our first clean sheet since April against West Ham. Unfortunately, we failed to score despite 22 goal attempts. 

But given our injury woes, and European commitments, sitting 7th at the half-way stage is remarkable. Our next Premier League game is 22 January, so hopefully time for injuries to mend.

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