Private debt in focus

In recent quarters, the outlook for private debt investments has remained broadly favorable. One sign is the covenant default rate, which has fallen despite a persistently high cost of capital.

According to the Lincoln International Proprietary Market Database the covenant default rate has fallen from 4.5% in the first quarter of 2023 to 3.4% in the fourth quarter.

As our macro credit research team has highlighted, the past few months have been characterized by a backdrop of resilience, including solid economic growth and fading concerns related to a near-term recession, especially in the U.S.

This, coupled with persistently elevated inflation, has caused the market to reprice its expectations for the start “timing” and magnitude of the Federal Reserve’s (Fed) interest rate cuts. While we still expect the Fed to begin its easing cycle in the second half of the year, we no longer view the risks to that (relatively wide) timeframe as skewed to the earlier side. Rather, we now view them as more balanced.

We see potential for the European Central Bank (ECB) to begin its rate-cutting cycle in June. Three factors underpin this view: the wide growth differential between the U.S. and the Euro Area; the fact the U.S. has experienced more upside surprises in inflation data over the past three months; and recent public commentary from the ECB (and Fed). Additionally, we expect the Bank of England (BoE) to begin easing around the same time as the ECB.

For private debt investors, this naturally raises concerns about the ability for businesses with floating rate debt to withstand this “high-for-longer” interest rate environment. The potential for inflation reacceleration is also a key risk to margins, in our view.

We believe that private debt will continue to prove a durable asset class in this environment. The negotiated nature of most deals, with favorable lending structures and underwriting standards offer protection. And in challenging times, private debt investors can be proactive, help solve problems and create better outcomes.

To show how this can work, we’re devoting this edition of Private Debt in Focus to four investments that became challenged and how we navigated the situation to optimize yields and returns.

Direct lending

The Investment:

In May 2022, we invested in a provider of IT, communications and print solutions to small and mid-sized businesses in the UK – a sub-industry where the direct lending platform frequently invests. Our GBP39 million financing supported the refinancing of the company’s existing debt and supported the acquisition of a target company in the cloud space.

We viewed this investment as attractive given that IT services is a large market benefitting from robust adoption of hybrid working environments, broad transition to the cloud and the proliferation of bring-your-own-device trends, which has increased the need for secure systems.

With respect to the company, it had a strong product and compelling value proposition for customers. The company also had an attractive financial profile which included recurring, visible revenues, solid EBITDA margins and good cash flow generation.

The Challenge:

Following an acquisition, the company faced material customer losses at the target company, as well as several integration-related issues which led to underperformance. Together, these led to a leverage covenant breach in December 2022.

We negotiated a temporary covenant reset, allowing it to carry a higher proportion of debt relative to earnings. But continued underperformance resulted in an additional covenant breach and a need for more liquidity by the company.

The Restructuring:

After several months of discussions with the sponsor, the new management team and chairman, we provided GBP4 million of additional financing to help the company manage its working capital needs and to meet overdue payments to suppliers, which had been affecting new business and operations.

In addition, this new liquidity would provide a buffer for the management to execute on a revised 18-month business plan which focused on retaining existing customers while winning new business, along with a strategic reduction in workforce.

The consensual, debt-led restructuring plan included the new-money commitment and capitalization of interest owed to us as payment in kind for up to 12 months. Payment in kind debt benefits from a premium margin, being priced above any cash paying debt and benefits from a compounding effect as it earns interest on interest until the debt is paid back. The team also negotiated enhanced economics and improved covenants, including a fixed and enterprise-value linked exit fee, which provides upside depending on the valuation of the company upon a sale.

We also received extended call protection should the company refinance our debt earlier than planned, as well as a base interest rate floor should we enter an interest-rate cutting cycle. Lastly, we negotiated significantly improved lender governance and control, and enhanced access and information rights, including three board observer seats, the ability to appoint a chief restructuring officer and additional independent board members along with the ability to control the exit or sale process.

The Outcome:

While this is a live investment, the initial execution of the revised business plan is tracking to expectations and we feel confident that our restructuring plan will help the company stabilize revenues, align its costs and de-leverage the business. This should position it for a potential sale to a strategic buyer or a private equity firm within 12 to 18 months.