No Apocalyptic Deleveraging Yet
“This recession will finally end the private-sector ‘debt super-cycle,’ says firm that invented the term” – MarketWatch, April 4th, 2020
Over the past decade, forecasters have been anxiously tracking rising corporate leverage levels and the proliferation of covenant-light loans, while lamenting the woefully declining credit quality of borrowers. Lenders could only “amend and pretend” for so long, they argued, and it would be just a matter of time before we witnessed an apocalyptic deleveraging event that would finally mark the end the current debt cycle. The sovereign debt crisis, tariff war, inverted yield curve, all came and went, but a global pandemic should have been the final straw. As infections and lockdowns spread in early 2020, commentators competed to see who could predict the biggest surge of bankruptcies and corporate defaults.
By Q3 defaults had fallen to below pre-COVID levels, and yields had declined dramatically across the board. In a shocking turn of events, debt issuance had surged to record levels, providing liquidity to healthy and distressed borrowers alike. The ultimate irony was, as S&P Global noted, investors “were so supportive that some of the corporate sectors that saw the largest increases in bond issuance relative to the prior five years were those most negatively affected by economic lockdowns.” Undeterred, commentators have now rolled forward their doomsday forecasts, bracing for an even bigger deleveraging and fallout in 2021. But what if we have collectively “broken” the corporate debt cycle? Consider the following three factors:
First, and foremost, is the Fed backstop, which involved unprecedented direct lending to both investment grade and distressed borrowers. Overnight, the Fed’s balance sheet nearly doubled to $7.4 trillion, all but ensuring that the Fed will be a permanent participant in private credit markets. Markets are inarguably in “risk on” mode, and it’s difficult to imagine any kind of crisis of confidence in the foreseeable future.
Second is the near-mythical “search for yield” and its side-effects, specifically the prolific rise of non-bank lending. Institutional investors, grappling with falling returns on fixed income and other assets, have pushed deeper into the private credit market. AUM at private debt funds has skyrocketed from under $200B in 2007 to nearly $900B, with $300B of dry powder waiting to be deployed. The new breed of lenders is more creative and better-equipped than traditional banks at segmenting and capturing risk premium at all levels of the capital structure. These investors, willing to take greater risks, were happy to put money to work during the pandemic, while banks battened down the hatches and sat on the sidelines. For these lenders, COVID has become a mere EBITDA adjustment, and most were willing to ride out the storm and “amend and extend” into 2021 leaving the search for yield poised to continue unabated into the future.
Last, but not least, is the evolution of lenders’ strategic options for dealing with distressed loans. Historically, a bank loan workout was a lengthy affair, with a forbearance or amendment followed by a two or three-year operational turnaround of the borrower. Today’s lenders prefer to move quickly to exercise their remedies. They are frequently turning to secondary debt sales, special-situation refinancings, carveouts or expedited sales of the company. Increased specialization means that there are buyers for every type of security, asset, and distressed business or division. For deeply troubled credits, options such as Article 9 foreclosures or Section 363 sales can be used as a tool to efficiently foreclose and sell viable assets at premium prices, and then wind down the remaining liabilities through either an in- or out-of-court process. As a top-tier middle market restructuring advisor, we employ these strategies (and more) every day on behalf of our clients, and have witnessed firsthand how lenders can now dynamically shift risks throughout this ecosystem. More and more, lenders rely on our firm to provide not only financial and operational support, but also integrated banking capabilities and increasingly advanced legal sophistication.
In sum, we could be witnessing the end of the broad-based credit cycle, and the start of a new era characterized by more complex, localized pockets of risk accompanied by fewer, but larger, distressed events. The current debt-cycle may live on for some time yet.
Konstantin A. Danilov is a Vice President at G2 Capital Advisors, which provides M&A, capital markets and restructuring advisory services to the middle market.