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Private Credit 

Chris Haffenden

The Christmas season appears to start earlier every year, and this is especially true for the traditional Santa rally for risk assets, which began well before Thanksgiving. European High Yield returned 2.86% in November, the second best return of the year, after January, with YTD returns now at 8.85%, according to ING’s High Yield research report —  Santa Came Early.

And risk appetite appears to be well and truly back for EHY with single-B names returning 11.46% YTD, well above the 7.98% gain for BBs. Not much seasonal cheer for a glass half-full restructuring journalist who feasts on distress, can’t get into the holiday spirit as he’s struggling to find the bottle opener, and all he wants for Christmas is for it to be over.

For me, there is never a season of goodwill. As Marshall Field says — Goodwill is the one and only asset that competition cannot undersell or destroy. On my Xmas wish list is a tougher set of IOSCO recommendations for regulators, and a much faster rate of amortisation.

Some glad tidings are to be found, however, for this restructuring grinch, who regular readers will know is sceptical about the quality and value currently on offer in European LevFin.

The Grinch: “One man’s toxic sludge is another man’s potpourri.”

Reasons to be cheerful — part three Cs

The CCC and below category for EHY has returned just 2.27% in 2023 and the spread gap is very wide to single B here — I would argue there is little room for single-Bs to outperform going forward — and recommend getting the barbells out to address the flabby belly of EHY.

European leveraged loans are more skewed to single-B issuance and finally following suit from their US cousins, with the rate of downgrades to CCC finally increasing. Loparex, Rohm and Veritas were all recently dropped into triple-hook, with the latter two having large cap stacks with a big CLO holder component.

Running the end November screeners for the latest Top of the Flops report, I feared the worst. But despite a sharp surge in bond prices as government bond yields tumbled, the number of bonds trading at stressed/distressed levels (at a STW of 8% and over) was 144 from 90 issuers, only seven and eight down from a month earlier. This is still higher than end-September (the rates puke) which had 127 bonds from 88 issuers trading above 8% spread-to-worst.

Similarly, after a sharp jump in October, there was little change in the number of loans indicated at stressed/distressed levels at the end of November.

So, still plenty of toxic sludge for us to wade through.

Effluent — a stream that flows out, such as from a lake or reservoir; an outflow; effluence.

Very apt in the case of Thames Water, whose regulated ring fence suffered a dividend outflow earlier this week to help service debt at its Kemble holding company. But this left a bad smell with regulator Ofwat who has raised objections to the water companies treatment, questioning whether the act was a breach of its license agreement and has asked for further information.

9fin’s Owen Sanderson wrote earlier this week:

“Thames Water said it paid a £37.5m dividend from its whole business securitisation up to the Kemble Water Finance Limited holding company, which would be retained to service the external debt of Kemble and Thames Water (Kemble) Finance, another holding company.”

Kemble sits outside the WBS ringfence, and the UK’s largest water company said this week in their earnings release there was material uncertainty “….related to the ability to refinance the £190m loan facility with Kemble Water Finance Limited before April 2024. This may cast significant doubt about the ability of the group and the company to continue as a going concern,” according to a statement published Tuesday (5 December).

Partial Thames Water capital structure as of March 2023, from company

Thames Water shareholders have been under pressure to put more equity into the troubled water utility, to reduce the level of debt and fund improvements to its creaking water infrastructure. But this can’t happen without either providing its shareholders a return, either via dividends or by growing the long-term value of the business, to enable a profitable exit.

In early October it published its business plan for the next regulatory period (2025-2030). It said there is an “asset health deficit” of £6.6bn in AMP 8 — the amount needed to get its infrastructure back up to standard. This is before an estimated £20-25bn of future investment.

To bridge the gap, shareholders have offered £3.25bn of equity injections over the five-year period, but in return the company wants technical tweaks to flatter its metrics, and big increases in customer bills (over 40%).

Their request says that Ofwat’s methodology doesn’t deliver financeable outcomes, with Thames pushing for a return on equity of 7.8% compared to the regulator’s assumption of 6.5%. According to an advisor active in the sector, Thames’ cost of debt is currently in the high 4s and for the equity it is around 8%, far away from the regulator’s current assumption of WACC in the mid-3s (in the current AMP7 regulatory period)

As Owen noted at the time, Thames’ plan assumes “no dividends are paid to our external shareholders during AMP 8” — 9fin emphasis — this form of language does not appear to rule out upstreaming cash from the OpCo to service the Kemble HoldCo bonds and private placements outside the regulated group.

And there lies the rub. While the back and forth between Thames and the regulator continues — draft determinations from Ofwat are published in May/June 2024, with final determinations in December 2024, with prices to become effective the following April — it must continue using dividends from the WBS to service debt at Kemble level in the meantime.

If Ofwat views these outflows as a breach of the license, it would effectively scupper plans to deal with debt at Kemble Finance level, and likely nix future plans by the sponsors to inject equity.

The positive view is that the regulator is under political and public pressure and therefore should be seen to be asking tough questions, but will probably acquiesce in the end.

The negative view, is that they have lost patience and this could be used as a proxy to trigger a default, and to find an alternative owner via special administration for Thames.

While special administration could help stabilise the business, any potential buyer will require clarity on future returns and the government would need to provide guarantees on CPI hedges and capex spending (maintenance capex is over £2bn per year) for at least until the end of the next regulatory period, so almost £14bn in total. But that it not all, we still need to addressing the £6.6bn deficit, plus potential huge spend to upgrade water and sewage infrastructure (estimated at £150-200bn for the industry, compared to a c.£80-85bn regulated asset base currently).

Water company sponsors need encouragement and a return to justify increased investment and inject fresh equity to reduce debt levels — the regulator after arguably dropping the ball and letting financial engineering get out of hand, is pushing for debt ratios to drop to 55-60% (Thames is over 80% currently) and for BBB-even ratings (a notch higher than currently, to encourage a greater margin of safety). The proposed new regulations mean that companies with a Baa2/BBB rating with negative outlook will be subject to a cash lock-up, which will stop dividends being made to the HoldCo. Thames is currently in this camp.

Politically, the water industry is a thorny issue, but arguably it is in the “too difficult” camp occupied by the NHS and Social Care, and may not be dealt with for a while. A lame duck government in an election year doesn’t help, and nationalisation appears to be off the table from an incoming Labour government, at least for its first term.

The water company sponsors recognise that equity dividends (if possible) will be unpalatable for the foreseeable future, but in return they need higher cash yields in the interim to help them service debt sitting outside their regulated ring-fenced debt.

There is also the question if this model — of using loans and debt at HoldCo level — is a sustainable and justifiable way to inject further funds into their businesses. This is not limited to the water companies, but other regulated utilities too.

It was expected Thames would remain in limbo until the final determination in a year and it could deal with debt at Kemble in the meantime. The latest developments throw doubt on this assumption, and it is no surprise Kemble’s 2026 SSNs have traded down into mid-50s this week.

Next Tuesday could be informative, with Thames in front of a House of Commons select committee, immediately followed by the regulator. We will be watching and listening with interest.

Ever the contrarian, one of my current interests is exploring the level of distress within private credit. It might be the golden age, but I am hearing anecdotal stories about a lot of activity in the background dealing with problematic older vintage loans.

This runs contrary to survey and reports such as the private credit default index from Proskauer, looking at hard defaults, and the Lincoln International data, which just covers covenant defaults.

The answer is that most deals are being dealt with and amended to avoid defaults. The problem is getting detail and names. There is little incentive for either party to disclose amendments, conversion from cash pay to PIK, or equity injections.

One indicator of stress is to look at the level of non-accrual loans in the investment portfolios of business development companies, closed-end funds which were set up to channel money into mid-market companies and hold a quarter of assets under management in private credit.

Indicative of potential problems in the sector, many BDCs have been trading at a significant discounts to NAV, in some cases over 20%, which shows that returns and exits are lower than anticipated, despite increases in interest payments (most deals were struck as floating rate).

In some cases it is possible to drill down in BDC reporting to individual line items. Otherwise, non-accruals levels are useful, as this designation indicates there is doubt over whether the principal or interest on the loan will be collected in full.

Another indicator of stress is the level of PIK interest as a proportion of investment income, which shows strains on the ability to service cash interest. Converting to PIK can enable borrowers avoid default and a change of status to non-accrual.

This is rising for a number of BDCs (unfortunately best data is for FY22) as shown by S&P below:

S&P also handily gives data on credit estimates for private equity-held private debt borrowers. It says “75% of companies with Credit Estimates have a score of “b-” and about 10% are in the “ccc” range. By contrast, only 36% of rated corporate issuers in North America are at B- or lower rating levels.” It is worth noting that Private Credit darling sector software has the second highest leverage at 7.8x, and the second-lowest interest cover at 1.4x.

For stressed refinancing, FCCR is more concerning than leverage, according to one debt advisor active in the private credit space. This has led to mezzanine and HoldCo PIK financing outside of the restricted group to plug the leverage gap to get stressed refinancing’s away.

More certainty over forward rates and business projections as Covid pressures, input costs and supply chain issues have eased, has prompted more amendments and extensions, rather than covenant holidays, they added. Extensions are longer, but most don’t beyond two-years, with margin bumps are skewed towards the lower end 25-75bps range.

It is worth noting that 2021 deals are the worst vintage, which is a hangover from the dry period of 2020, with lots of competition for lenders. Whereas a deal could be 7x levered at issue in 2021, leverage points are now just 5-5.5x in 2023.

Source: Lincoln International EU Insights report

Lincoln International note that 15% of private credit valuations they had performed in 2023 had amendments, with the pace increasing throughout this year. This is 550 companies globally.

There is still more investigative work to be done.

For example, how prevalent are the use of NAV loans proceeds to invest in problematic portfolio companies — as was the case in Finastra. The role of continuation vehicles to extend sponsor runway is another area of interest, as is whether semi-liquid investment vehicles can also provide clues on individual loan performance.

My weekend reading is Muddy Waters’ Blackstone Mortgage Trust short-seller report, to see if there is any read across into private credit and the valuation of alternative managers. The world of valuations of private debt and private equity and their vehicles will be a hot topic for 2024.

The Signa Holdings fallout continues to dominate my reading material this week, leaving little time for much else. I would recommend Jack Sidders piece on Bloomberg — Signa’s lofty property valuations point to brutal pain to come as the best of this weeks crop

Away from Signa, more evidence of the pain in commercial real estate, with No 1 Poultry, the home of rooftop city restaurant Coq d’Argent is up for sale, but the bids are in the mid 70s compared to a £135m valuation, not enough to cover Bank of Ireland’s £90m loan.

Alternative suggestion for Person of the Year from High Yield Harry

It was good catching up with my season ticket mates at the Amex on Wednesday. The after party in Athens after our qualification was wild, with Fat Boy Slim taking over a nightclub set for the fans until 4am, with Chairman Tony Bloom in attendance.

A narrow 2-1 win over Brentford was capped off by a winner from 18-year old Jack Hinselwood, a midfielder playing at right back whose dad played for the Albion from 2002 until 2009. The Brighton Bard nailed it…

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