Key to our investment recommendation process is providing clients with clarity, confidence, and purpose.

In today’s market environment, providing investors with clarity is often easier said than done. Numerous prognosticators come out during market disruptions, and with many of us working from home it’s harder to avoid the noise populating TV broadcasts and newsfeeds.

Naturally, investors want to know: Will this correction be worse than the last? What makes this time different?

As advisors, how do we answer these questions? Can we answer such questions?

The questions are also harder to answer for private investments. Public companies are beginning to announce earnings, and public markets, having fallen substantially from 2019 highs, have also had a rebound off initial lows. However, we’re still in the earlier stages of assessing COVID-19’s impact on private market investments. Some initial signs, though, can be found in the leveraged loan markets.

First, some background. Leveraged loans are below-investment-grade bonds. Unlike other high-yield (i.e. junk) bonds, leveraged loans are typically senior secured (collateralized) notes and pay floating interest rates. But, they are also less liquid and less regulated than traditional high-yield bonds. Leveraged loans are also issued by companies typically with higher risk of default. The term “leveraged” refers to the fact that these companies have more debt (i.e. leverage) on their balance sheets than higher quality companies.

Historically, banks have been the largest provider of capital via leveraged loans. Yet, while banks still have significant exposure to leveraged loans, regulations spun out from the Great Recession have severely restricted their ability to lend to these riskier companies. But, the need for debt capital simply didn’t disappear with these tighter regulations. Rather, it has exploded, and debt financing has been boosted by the vast non-banking network consisting of private credit funds, insurance companies, pension funds, and other institutional investors. Further, private equity firms have increasingly turned to these non-banks providers to finance their corporate buyouts. 

It is in this leveraged loan / private credit system where we’re starting to hear from several portfolio managers and senior executives. Surprisingly, a few have been reticent to acknowledge a deterioration in the fundamentals of their investment holdings and the companies to which these positions are tied. In fact, more than one has blamed the decline in valuations and performance entirely on technical driven selling.

Forced liquidations and panic selling have certainly exacerbated the decline, but when the economy is practically shut down, and corporations are likely to see record declines in revenue, placing blame solely on technical-driven factors is pulling wool over the eyes of investors. These managers are trying to impart confidence, but let’s try to instill a bit of honesty, and clarity, for our readers. With more capital tied to private equity and private debt than ever before, watching these two intertwined assets will be extremely important in determining the severity of the impending recession and when future investment opportunities may arise.

According to Fitch Ratings, leveraged loan default rates in 2020 are forecast to reach 5%-6%, or $80 billion in deal volume, which is more than the $78 billion that defaulted in 2009. In 2021, Fitch projects defaults to range between 7%-8%, with a cumulative two-year total surpassing $200 billion, or 15% of the $1.4 trillion leveraged loan market.[i] Still, these figures don’t address the enormous amount of capital tied to debt not syndicated by banks. Unfortunately, this value is extremely difficult to ascertain, but estimates for private credit range between $700-$900 billion in committed capital.[ii]

A large portion of this debt capital is tied to private equity (PE) buyouts, purchases which are nearing record-high multiples of debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization)—levels that were last seen in 2007. Not only that, but PE firms have been artificially inflating operating earnings through “addbacks” such as projected costs savings, resulting expenses getting added back to operating income. This is not new to the industry, but it has the effect of making the debt-to-EBITDA ratio look more conservative (i.e. lower) and thus more appealing to investors. This issue has been highlighted in the past but could now exacerbate the difficultly of exiting these investments at multiples that generate positive cash flow for investors.

As noted by the WSJ, PE managers are being forced to make “unknowable assumptions” about how quickly consumers will be able, or willing, to start spending again. However, these assumptions are being made to determine which portfolio companies to support and which to abandon. As PitchBook noted in a recent research piece, PE firms are in “triage mode.” These managers are attempting to hit target returns that were established years ago and are now near impossible to achieve; no previous forecast could have predicted the current situations we are in. Hitting target returns will be especially difficult if uninvested commitments—and there is a lot of that dry powder sitting around—are used to keep existing investments afloat instead of pursuing new opportunities with greater upside potential. It’s a complicated balancing act between supporting existing portfolio companies and opportunistically investing in other companies that have fallen to distressed levels; not to mention, selling each investment in a timely manner that generates those target returns.

Unfortunately, many smaller PE firms won’t have enough capital or support from their Limited Partners to do all of the above. While unlikely, it’s also worth noting that institutional investors—the Limited Partners that are the source of that uncommitted capital—are not required to provide the cash when called. Although they’d face steep penalties for not meeting capital calls, we are in unprecedented times and nothing should be written off as impossible. Projected losses may be so severe that the penalty paid is the more cost-effective route. This private market turmoil will take months, and likely several quarters, to unravel.[iii]

We understand why private investment managers are trying to remain upbeat about their portfolios. As individuals, humans can be indomitably optimistic. Black swan managers aside, investors don’t choose to participate in the markets with a pessimistic outlook. But, as a group, it’s imperative to help each other prepare for unexpected negative events. We’re all in this together—at SineCera Capital, no message is more important to share with our clients.

As always, if you have any questions, please do not hesitate to contact us.

Best Regards,

Adam J. Packer, CFA®

Chief Analyst | SineCera Capital