Why Debt Investors Must Think Outside the Box – Milken Panel
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While every industry has undergone significant change over the years and the course of the pandemic, debt markets may have evolved more than most. The recent Milken Global Institute Conference highlighted how these markets have changed and what they might look like in a post-pandemic future.
“The financing industry has changed markedly over the last while,” Aine O’Flynn, Head of Investment Banking Capital Markets at BMO, told the Special Situations in Unusual Times panel. Moderated by William Lee, Chief Economist at the Milken Institute, and featured Ben Black, Founder, and Managing Partner at Fortinbras Enterprises, Andrew Milgram, Chief Investment Officer of Marblegate Asset Management, and Michael Patterson, Governing Partner at HPS Investment Partners.
O’Flynn pointed out that before the Global Financial Crisis, the risk unsecured high-yield bonds were typically the most junior debt in a capital structure, particularly for LBO. However, over the past several years, there has been a noticeable shift to second-lien debt and, more recently, “unitranches,” as the risk capital of choice. She said covenant-lite loans – loan agreements with no financial maintenance covenants – were once the exception but are now the rule. While leverage multiples remain fulsome, as valuations have climbed, so has the equity support underlying today’s debt levels.
O’Flynn says she has been giving a lot of thought to these issues lately and how this current market structure might react in another downturn. There are concerns, and she noted: higher leverage, increasingly aggressive terms, tighter pricing, and more investor concentration in some situations.
But, at the same time, the high yield default rate is under 1%, interest rates are still at near-record lows, and capital is abundant. So, while there aren’t any obvious signs of distress, “the one thing I know for sure is that the rate of change of everything is accelerating,” she said. “What we don’t know is what re-regulation is going to do? What about ESG and technological disruption? How are these thematic issues going to impact the entire investment complex? How do we get ready for that?”
There’s no clear answer to those questions, O’Flynn told the panel. However, the best thing that investors and industry players can do is to think outside the box and consider all the possibilities. “We need to have the sharpest expertise in credit and capital, but we also need to be acutely aware of what’s going on in the innovation front,” she said. “We have to have our eyes wide open and be on top of our game to navigate through that next downturn.”
People must also be more forward-thinking and consider more than just the creditworthiness of these companies. “At least for us, we have to really think expansively about how we’re going to tackle a bunch of these thematic issues that can and likely will come out of the blue and disrupt the status quo,” she said.
BMO’s adapted to the shifting debt landscape, in part, by participating in the direct lending market through a partnership with Oak Hill Advisors, said O’Flynn. “We can now provide a complete one-stop financing solution,” she explained. “We can offer clients everything from the traditional syndicated product to a private debt solution with unitranches and direct second liens – it’s something that’s working very well for us.”
No Covenant Challenges
Michael Patterson, whose HPS Investment Partners lends money to businesses, said that people in his industry – and in the public and private markets more generally – are looking at the world through rose-colored glasses. The quality of the average sponsored backed leveraged buyout document, he said, is much worse today than it was six years ago. Still, with many people waiving covenants or not having any in the first place, defaults will remain low. “The level of defaults will be artificially depressed,” he said. “There will be situations that would have been a default in today’s market that are not a default because there’s nothing to default on.”
This presents some problems when companies do find themselves in trouble, said Marblegate’s, Andrew Milgram. “If the guardrails are gone, then at the moment of defaults, you have a company where a simple rearranging of the deck chairs in the capital structure just won’t work,” he explained. Instead, companies must take a far more hands-on approach to restructuring, while lenders may have to battle it out to see who gets paid back first. “When it does get to that moment of truth, it’s a much worse situation than it was in the past. And, with loose credit agreements, you’re inviting this trend of lender-on-lender violence that has been on the rise in the market. Secondary buyers, like us, will come in and utilize the gaps in the credit agreement to create advantages for ourselves and our investors.”
Be flexible and manage risk
Ultimately, investors and lenders need to be flexible and adaptable, says Fortinbras’ Ben Black, but you don’t want to push things too hard, because “that’s how you get situations like cov-lite where you’re trying to fit a square peg into a round hole and really come to regret it later on,” he said.
Milgram added that investors need to be prepared for a more difficult credit market ahead, while an extended inflationary period could have a lot of unintended consequences. “We are probably facing a tremendous amount of structural change in the way the credit market works. That will be partially driven by economics, partially driven by realized outcomes, and I also think that it is probably a bit of wishful thinking to suspect that the entirety of the unregulated market for credit remains unregulated,” he said.
Patterson agreed that the market structure has changed and that there will be more volatility ahead. However, the most interesting things going forward, he noted, “will be injecting par dollars in distress situations just as much as you’re buying things in the secondary market.”
When it comes down to it, though, it’s important for companies, and especially one like BMO, to pay careful attention to all the risks and continuously monitor the situation, said O’Flynn. “You have to really dig deep into the credit and into the issues,” she noted. “We are always looking at ways we can mitigate our risk, share our risk, and hedge our risk.”
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