Hamilton: It goes back to the underwriting and the analysis of the underlying collateral and having a “Plan B” if the borrower’s plan fails. For example, if you have lent against a commercial property, know- ing there is a strong alternative use value – for example, residential – is important and we have seen this recently with loans secured against retail assets.


PI: What impact have new players entering this market had on covenants? Atkin: There has undoubtedly been an erosion of covenants and spreads have compressed. You have to look at the market and ask how a private asset with higher leverage and a covenant that has been eroded stacks up against debt assets in the public markets. Always look at the relative and absolute value when looking at these deals. Accept that life changes and try to stay at the leading edge of what is available. New and unfashionable sectors are often best because the moment things become fashionable they become more heavily bid, so poorer value. Halfon: Although there may be a lot of competition, to do something as complex as private debt well, you need a bit of history, you need resources and expertise that are not readily available to everyone. We are a big bank but it took us 30 years to build a track record in the US. On paper, there seems to be a lot of supply, but you need to look hard for good quality. Hamilton: In real estate debt we have not seen weaker covenants in terms of loan-to-value and interest cover ratio protections. One of the things that has changed, which is a worry, is call protection. Typically for higher yielding strategies, a borrower has a plan to improve a building and sell it for a profit and would take out a three to five-year loan. If that property is sold early, say within 18 months, a lender needs to be protected somehow from the loss of coupon, typically by the loan guaranteeing some mini- mum return. But these are disappearing. That’s a worry. As an investor you want to keep your money working.


The other thing we are seeing more of is that in a few cases borrowers are re-financing the debt and taking a material amount of equity out of the asset – essentially crystallising a profit. That changes the dynamic of how they are going to act if the asset subsequently gets into trouble. Debt managers are aware of this, but some are underestimating how the borrower will act differently to the situation where they have not de-risked. That is what we have seen with real estate loans. The concern is if the borrower had not taken equity out of the structure, they would work harder and adapt the business plan to get problems sorted rather than hand back the keys.


The other aspect I am wary about, is not so much covenants being weakened, but a manager growing its product range and fund sizes leading them to make loans against assets which they would not have done a couple of years ago. Martin: The term “cov-lite” has been talked about for many years in the US loan market. I try to differentiate between the US and the European loan markets, they have different dynamics. I pre- fer European loans because they do not have the same market dynamics and pricing issues that you face in the US. Cov-lite is a change in the European market but is not a reason not to do it. I sometimes wonder if managers proving loans are relying too much on having many covenant provisions. Hamilton: Covenants when structured properly do work. In real estate, covenants protect managers by letting them take control


of assets early to manage an issue. Where they have been in junior positions, they are protected from the actions of the senior lender by having some breathing space to sort the problem out. For example, if an inter-creditor agreement between senior and mezzanine debt is pretty weak, a forced sale of the asset by the senior could happen at the worst time resulting in large losses for the mezzanine provider. Martin: You have to make a judgement on the spread you are getting, the underwriting, how you deal


16 October 2019 portfolio institutional roundtable: Private debt


Page 1  |  Page 2  |  Page 3  |  Page 4  |  Page 5  |  Page 6  |  Page 7  |  Page 8  |  Page 9  |  Page 10  |  Page 11  |  Page 12  |  Page 13  |  Page 14  |  Page 15  |  Page 16  |  Page 17  |  Page 18  |  Page 19  |  Page 20  |  Page 21  |  Page 22  |  Page 23  |  Page 24  |  Page 25  |  Page 26  |  Page 27  |  Page 28  |  Page 29  |  Page 30  |  Page 31  |  Page 32