Direct Lenders Should Prepare for Private Credit Restructuring

As we enter a period of continued macro-economic uncertainty, characterized by heightened geopolitical risks, global inflationary pressures, and uneven growth, direct lenders should be ready to deal with stressed and distressed investments in their portfolios as the private credit market endures some of its most challenging conditions yet.

In the 2008 financial crisis, non-bank private credit was still in its infancy. Most of the significant restructurings during that period involved groups of bondholders, collateralized loan obligations, or banks.

The industry has weathered subsequent challenges such as Brexit and the Covid-19 pandemic, but these occurred during periods of greater liquidity and low interest rates. The real test for private credit may be yet to come.

The private credit product has evolved from its mid-market origins to a viable replacement for, or compliment to, syndicated loans and high yield bonds, with larger facilities often provided by a club of direct lenders. As direct lenders have moved upmarket into larger, more complex capital structures, private credit documentary terms and structural protections have increasingly converged with those of term loan B and high yield financings.

Despite this convergence, certain differences typically remain that may affect how a restructuring would play out in private credit transaction, as opposed to a broadly syndicated or capital markets deal, including the way in which direct lenders are likely to react.

Skin in the Game

In contrast to a high yield bond issuance or the distribution model of underwriting banks on a syndicated loan, the fundamental premise of a private credit transaction is that the lenders will “take and hold” the debt.

This is reflected in private credit documentary terms, which typically have more covenant protection but less flexibility for a lender to transfer its commitments to new lenders than on a syndicated term loan or high yield bond.

Restrictive transfer terms might include less extensive lists of pre-approved transferees, fewer rights to freely transfer the debt when an event of default is continuing, tighter restrictions on transfers to distressed debt investors, and stricter borrower consent requirements for other transfers.

Even if a lender is permitted to trade out of a troubled asset, limited liquidity in the private market makes new lenders harder to find. Any new lender would likely expect a significant discount to par in such circumstances, which is unpalatable for direct lenders who are unwilling, or indeed unable under their fund documents, to crystallize a loss.

As a result, direct lenders are more likely to engage constructively with the borrower to find an early solution to whatever problem has beset it. However, where there is no apparent solution that involves maintaining the company as a going concern with the existing sponsor in place, a direct lender may also be prepared to enforce security and take ownership of the borrower, though typically only as a last resort especially where there are broader relationship factors at play.

A Seat at the Table

Over recent years, increasing competition for assets has resulted in weakened covenant protections for direct lenders, particularly where borrowers would otherwise be able to access debt capital markets. Security-light structures, fewer and looser (or indeed a lack of) maintenance covenants, flexible EBITDA and leverage metrics, generous baskets and thresholds for debt incurrence, and a greater ability to move assets out of the security net or the banking group are some of the changes to documentary terms benefiting borrowers and their sponsors.

This erosion of terms has meant that direct lenders may have fewer levers to force a borrower to engage in early restructuring discussions. At its most extreme, this leaves direct lenders vulnerable to the kinds of liability management exercises by sponsors that had previously been limited to term loan B or high yield financings.

A Problem Shared

Historically, bilateral lending was favored over club deals as direct lenders sought to retain control over any discussions with their borrowers. As club deals become increasingly common for larger private credit transactions, with some of the largest deals resembling a private syndication, there may be no single lender controlling the voting rights or potentially even having a blocking stake.

Nonetheless, there generally remains an alignment of interests amongst direct lenders which may limit the ability of a borrower to play creditors off each other. By contrast, the interests of bondholders or term loan B lenders can vary significantly, largely driven by the price point at which they entered the deal and their objective when buying in.

Unlike direct lenders, which originate a deal and then expect to hold the debt to maturity, the controlling bondholders or term loan B lenders in most distressed names tend to be specialist distressed debt investors, who have bought in at a discount with the intention of either trading out at a profit if the price rebounds or, if necessary, taking the equity through a restructuring process. The interests of these investors will therefore vary considerably to most direct lenders in private credit deals, or indeed to other investors who have bought into the same deal at or close to par.

Given the difference in documentary terms between most direct lending transactions and the debt capital markets, and the divergent approach of investors in each asset class, it remains unknown how restructurings of so-called “hybrid” capital structures, involving both a private credit and a broadly syndicated tranche, will play out. The fall-out of the GFC provides some clues as to how senior/junior structures might unravel, but the interplay is less clear where such tranches rank equally with each other.

Prepare for Uncertainty

Direct lenders should prepare to work out distressed investments as economic conditions evolve away from an extended period of relatively benign market conditions.

Prudent managers have been tooling up with portfolio management functions and in-house restructuring teams alongside existing operational and private equity capabilities at multi-asset funds. These managers will be better placed to proactively manage a restructuring to preserve maximum value.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Jacob Durkin is partner in Simpson Thacher’s banking and credit practice.

Marc Hecht is partner in Simpson Thacher’s restructuring team.

Matthew Hope is counsel in Simpson Thacher’s banking and credit practice.

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