Direct lenders navigate rough seas | Paul Hastings LLP

Private Debt Investor-

According to partners William Brady, Kris Hansen and Jennifer Yount, direct lenders need to be strategic about higher default rates.

Q: What challenges do direct lenders face in the current environment?

William Brady: Direct lenders face challenges on two fronts: they are under tremendous pressure to deploy capital in a still highly competitive market and, at the same time, they need to protect against downturns to maximize value and returns. They must remain commercial and competitive while protecting their LP’s investment in these times of incredible uncertainty. This requires a delicate balancing act.

Kris Hansen: Given the global macro environment, direct lenders should prepare for a higher default rate. We work with our clients to draft their new deal documentation in a way that remains competitive but also protects them in the event of a recession. In the event of default, both issuers and sponsors want maximum flexibility, which comes at a price for both parties.

Jennifer Young: With increasing portfolio diversification – across geographies, industries, products and asset classes – direct lenders need diversification of expertise for their investments. The typical analysis of “how does a lender get out of credit before a lender gets credit” often requires a range of specialists across asset classes, products, industries and geographies .

Q: How can managers maximize opportunities on initial transactions to tighten certain credit terms?

JY: Many direct lenders keep a wish list to tighten terms. But in this market – which remains competitive – it’s not realistic to have every item on your wish list. You have to prioritize. For these priority items, direct lenders signal them earlier in the process to avoid surprises later in the negotiations.

WB: The focus is on the common thread between staying competitive and protecting downsides – primarily leakage and leverage. This applies on both fronts to credit arrangements with the borrower (J.Crew, Chewy, Envision, etc.) and other lenders (Serta, Revlon, etc.). It is essential to focus on the most critical “must have” underwriting protections while remaining commercial on other less critical terms.

KH: We do a lot of bridging loans in distress situations and rescue financing in larger distress scenarios. It is essential that those negotiating the documents in these situations have in-depth experience of transactions in which sponsors and lenders have taken advantage of document deficiencies so that areas of exploitation can be dealt with in the most advantageous manner for the lenders. .

For example, it is common for a sponsor to have a non-wholly owned subsidiary, which has operated in the past. However, it remains difficult to negotiate this outside of credit agreements because sponsors still control the flow of transactions and so lenders must protect themselves in other ways.

Many of these exceptions in the documents have been used to keep lenders at bay and favor some lenders over others. In private credit, there are generally fewer lenders and they tend to know each other, so there is a higher trust factor, but that does not replace experience with documents and knowledge of where look for potential problems.

Q: What can direct lenders do to protect existing transactions and maximize value?

WB: It is essential to be proactive and take the lead while communicating strategically with other interested parties, including certain lenders. Who you talk to or don’t talk to, and what you say or don’t say will matter. Navigating towards a consensus among certain constituents to maximize value is not an easy task, but it is achievable with a proactive plan. It is also essential to understand the cause of the distress, as every agreement is different and there is no “one size fits all” solution.

JY: We maintain a list of our distressed credits and frequently review the list to determine if any trends are emerging and, if so, whether these trends are consistent with available data, geopolitical events or court cases. When a trend or theme emerges, we communicate with our direct lender clients. As examples, we have seen some themes related to labor shortages and data privacy.

To protect value, direct lenders are often in frequent communication with the company or private equity sponsor to ensure everyone is on the same page about the issues, plan and next steps. . Situations with this approach are where we see the most success in terms of stabilizing credits.

KH: It is very important to be able to have an agency relationship that favors the lenders, especially in difficult situations. We have noticed that if we inherit an agreement it can be very difficult to remove the agent and many sponsor-friendly arrangements rely on the consent of the agent. Therefore, it is very important to have an agent who is willing to communicate with lenders and follow their guidelines and appoint this type of agent initially or get to work early to replace the incumbent agent.

Playing defense also means knowing your rights and making sure you have the right partners. All this advance communication will allow managers to react quickly and it is absolutely essential. The relationship between lenders and issuer does not have to be adversarial and, in fact, should aim to work together to bring additional flexibility to a business.

Q: What new opportunities might be available in these rough seas?

JY: Turbulent markets offer many opportunities, but the opportunities in this recessionary environment differ from previous recessions. Three stand out for me:

First, on the product side, we are seeing private lenders focusing on asset-based lending or hybrid asset-based lending, which historically was a product that only banks offered. Private lenders are also focusing more on structured finance products, real estate and infrastructure. Second, in terms of industries, we’re seeing private lenders focusing more on sports and entertainment, financial services, and industries that are seeing a resurgence due to federal and state legislation, like clean energy and healthcare. health. Third, structures have become more bespoke and are specifically tailored to investors’ business and return objectives.

KH: We are seeing a move on our side towards a more structured hybrid debt and equity opportunity in an effort to blend returns and address the potential for increased market risk. Capital providers able to combine both private equity and private credit see it as a way to earn returns. Obviously there are enforceability issues with the restrictive covenants and the trick is still in the drafting.

WB: Every situation is different. Commercial and legal due diligence will be essential to understand if, and where, opportunities can be found on each particular transaction. Liquidity and debt service will be a determining factor for many borrowers who are faced with falling GDP, higher labor costs, inflation and rapidly rising interest rates. interest. Liquidity solutions can take many forms and potentially in many parts of the capital structure.

Strategies for finding authorized liquidity solutions while protecting downside risk will be different in every trade. When it comes to leaks, governors on RP, RDP, investments, and affiliate transactions have a premium. With regard to leverage, managers should focus on limiting all leverage with a premium on locking in seed debt and preserving MFN protection on all bet debt, regardless of size. classification (incremental, equivalent incremental, debt ratio or other). not

Q: What are the opportunities to go on the offensive in existing agreements?

KH: It always starts with a covenant analysis to determine what opportunities exist throughout the document – ​​how much leverage the lenders have and how much leverage the sponsors have. It’s about finding a capital solution and that can be tricky when some lenders have a very different cost base than others and some hold the loans through vehicles that may not be able to operate from as flexible as others. Being able to see the full playing field and understanding who can play where on that field is essential.

The market in recent years has had lenders evaluating their ability to jump the line and swap their debt into a different category to get ahead of other lenders. This is a solid offensive strategy, but people need to be careful to consider the responses to these actions and their place in the larger market.

When on the offensive, lenders need to consider whether there is open market buying, whether there is a lack of protection from a pro rata sharing perspective, or whether there is ring-fencing around important assets. However, lenders should also keep in mind that in this market they are often dealing with the same people around the table. So they need to be careful to only focus on what’s best for their LPs in a single investment.

Finally, lenders should always consider buying or refinancing the asset-backed loan in a distressed situation in order to support the more favorable inter-creditor position that ABLs often have and to use the more liquid collateral associated with ABL. This often allows lenders more willing to deploy flexible capital to do so more quickly and efficiently.

WB: All of this underscores the importance of understanding the existing documentation and, again, the cause of the distress. Good companies with bad balance sheets are prime targets for opportunistic lending. With the large amounts of dry powder that didn’t exist during the Great Recession, our current economic environment is unlike anything we’ve seen before. Opportunities will surely follow.

This article originally appeared in Private Debt Investor magazine.

About Galen A. Williams

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