The Credit Debacle 2.0

This article was co-authored by Cook Pine Capital and Star Magnolia Capital

COVID-19 Has Triggered a Corporate Credit Cycle

Shinya joined Cook Pine Capital in February 2006 and one of the very first projects was updating “Current Macro Economic Environment and Opportunities in Distressed Securities” presentation. Graduating from the university in 2003, he missed the previous credit down cycle from 2000 to 2002, but he knew something was coming.

It was two years before the financial crisis led by credit excesses in the mortgage and household markets. This time we see problems in corporate debt markets. While few anticipated the bull market would be ended by a virus, we believe COVID-19 has triggered the next credit cycle.

Distressed Opportunities – June 2006

The Credit Debacle – September 2007

While Households and Banks Deleveraged, Corporate and Government Leverage Increased

After the 2008-2009 financial crisis, households completed a painful deleveraging, and tight regulations forced financial companies to strengthen their balance sheets. In contrast, nonfinancial corporates and the federal government substantially expanded their balance sheets.

Total Liabilities to GDP

Source: U.S. Federal Reserve

Leveraged Loans and Private Credit Fueled the Borrowing Binge

After the 2008-2009 financial crisis, the bank loan market shifted its source of funding away from banks and securities firms. At the same time, two types of debt securities—leveraged loans and private credit—outgrew the overall debt market by wide margins compared to corporate bonds (including high yield).

Source: Crescent; S&P LCD; SIMFA

Amid low and negative rates, investors searching for yield increasingly turned to managers investing in leveraged loans and private credit.

Source: Cook Pine Capital

Leveraged Loans Fueled Private Equity’s Boom

In 2018, the loan market surpassed the high yield corporate bond market for the first time ever. Easy lending terms helped private equity firms to bid higher prices for companies even as regular corporate M&A activity slowed. Nearly 40% of M&A transactions are now backed by private equity.

Source: PIMCO; BofA Merrill Lynch; Crescent; S&P LCD

Awash with liquidity, the leveraged loan market experienced a significant decline in quality, with covenant-lite loans that provide limited lender protection becoming the new norm. Nearly 80% of new loans were covenant-lite in 2018. The deterioration in underwriting resembled the rise of subprime mortgage origination in 2002-2006.

Source: Credit Suisse Indices; U.S. Financial Crisis Inquiry Commission Report

As CDOs and CLOs Fell Out of Favor, Yield Hungry Investors Also Turned to Private Credit

After the last financial crisis, CDOs and CLOs gained notoriety as they provided extra leverage during the bubble. While investors did not entirely abandon CDOs and CLOs, both vehicles lost appeal. In contrast, private credit, which primarily engages in direct lending, became a preferred destination for investors hungry for yield.

Private Credit is Today’s CDO/CLO ($bn)

Source: Preqin

Who Loves Private Credit?

Many institutional investors shifted their equity exposure (especially in hedge funds) to private credit. Private credit’s higher and (apparently) more stable yields caught the attention of pension investors, in particular, as many of them were struggling with almost insurmountable funding deficits.

Source: Business Insider; Preqin

49 of 50 State Pensions Are Underfunded (as of 2017)

Source: The Pew Charitable Trusts (2019)

Why Did Investors Fall in Love with Private Credit?

Private credit’s promises were too good to be true. Private credit became popular among institutional investors because the asset class performed very strongly after the last crisis. According to E&Y’s study, private credit (labeled “alternative lending” below) generated 6.44% return with seemingly low volatility (0.59%), as private credit investments are not subject to mark-to-market risks. In turn, many private credit managers pitched themselves as if there were not many risks associated with the strategy.

Low Risk; High Return?

Private Credit Pitch Sample

Source: E&Y (top); Crescent (bottom)

Yet, Private Companies Are More Levered and Vulnerable

In fact, private companies are far more levered than publicly listed companies (4.7x vs 2.0x), and highly levered small companies are more vulnerable in a recession. Moreover, the absence of a mark-to-market does not equate to low risk of permanent capital impairment. We believe that many investors in private credit have underestimated the associated risks.

Private Companies are Ultra-Levered

Even in a Best-Case Scenario for Recovery from COVID-19, Many Levered Companies Will Fail

While a trade war, rising inflation, or maturity walls could have triggered the next recession, ultimately a global pandemic compounded by an oil price war between Russia and Saudi Arabia has ended the longest economic expansion in history (127 months through February 2020). Although the extent of the economic pain will depend on how long closures and social distancing must continue, many highly levered companies will face liquidity or solvency issues even in a best-case scenario for an economic recovery. Consequently, we believe extremely attractive distressed investment opportunities will emerge over the coming quarters.

This Time, Leveraged Loans & Private Credit Will Be the Epicenter

Unlike last time, some of the best opportunities will be found in the leveraged loans and private credit of smaller companies, often backed by private equity sponsors. The credit markets for smaller companies are less transparent and highly fragmented. As a result, experience and industry knowledge will be critical to harvesting upside and avoiding potential landmines.