What Is Private Credit?
What is private credit? No one knows, but it sounds provocative; it gets investors going. Jokes aside, a recent report from the Federal Reserve has a good definition: non-publicly-traded debt provided by non-bank entities that “involves the bilateral negotiation of terms and conditions to meet the specific needs and objectives of the individual borrower and lender, without the need to comply with traditional regulatory requirements.” Private credit lending deals typically involve a single direct lender or a “club” of a few unaffiliated lenders. Since borrowers and sponsors choose their lenders in connection with financing, private credit is a relationship business. The sponsors usually have a relationship with at least one of the lenders prior to doing a new deal, and the lenders usually have relationships among themselves. In times like the present, where the amount of private credit capital available to deploy exceeds the opportunities, these relationships are especially important. Private credit is typically not rated, nor broadly traded with public pricing quotes. Private credit loans are less liquid than syndicated loans, and they are less likely to be traded due to borrower financial distress and/or for purposes of avoiding involvement in a restructuring transaction.
Restructuring Trends in the Syndicated Loan Market
Public Trading and Ratings; Lender Organization
In contrast to private credit, syndicated loans are rated and broadly traded with public pricing quotations. Moreover, the originating lenders may sell the loan if a borrower becomes stressed (or distressed), often at a price well below par to a fund not previously invested in the credit. Further, such buyer may be purchasing the loan specifically in anticipation of restructuring or a liability management transaction.
Importantly, as a result of these dynamics, lenders often proactively organize into “ad hoc” groups at the first sign of operational or balance sheet stress, in anticipation of a restructuring transaction or new money capital raise. Lender organization itself may increase volatility, as news of lenders organizing will often get leaked to the market and cause lenders to sell out of the loan, which may cause loan trading prices to decrease further. In a worst-case scenario, vendors, customers, and landlords may cut exposure to the borrower (e.g., tighten trade credit). Early lender organization may frustrate the sponsor and/or the borrower; however, if it causes loan trading prices to decline, this may present an opportunity for the sponsor and borrower to capture discount via debt purchases or exchanges.
Non–Pro Rata Liability Management Transactions
Lenders often view the benefit of ensuring participation in an ad hoc group and inclusion in the “Required Lender” group as outweighing any costs or downsides of early organization. In contrast to private credit deals—where the lenders know who the co-lenders are and how much of the loan they hold—syndicated loan holdings are not disclosed unless the vehicle holding the loan, such as a business development company (“BDC”) or collateralized loan obligation (“CLO”) fund, has to publicly report its holdings. Thus, the lenders are in a literal race to join an ad hoc group that holds loans in the aggregate constituting “Required Lenders,” which permits (or ostensibly permits) a wide range of amendments and other restructuring transactions.
While there have always been economic benefits to controlling Required Lenders, the economic value has significantly increased owing to the well-documented trend of non–pro rata liability management transactions—colloquially referred to as “lender-on-lender violence.” The crux of these transactions—which come in many different flavors—is that the borrower receives new money from the ad hoc group, and the loans of the ad hoc group are elevated in lien and/or payment priority compared to the loans held by those not in the ad hoc group. This may also come with other bells and whistles, like a significant make-whole or double-dip structure.
A corollary of the opacity of lender identity and holdings in syndicated deals is the potential fluidity of the Required Lenders. An ad hoc group that holds 60 percent of outstanding loans today and, therefore, constitutes the Required Lenders could easily lose that status. The remaining 40 percent of outstanding loans could be held by twenty different institutions holding 2 percent each, or it could be held by one institution. In the latter scenario, there is a real risk that the 40 percent lender could either persuade a few members of the initial ad hoc group to disband and join the 40 percent lender’s new group, or just buy their loans and then constitute Required Lenders by itself.
Lender identity and holdings opacity significantly increase restructuring process risk and volatility in a world where non–pro rata liability management transactions are common. Ostensibly to address this risk, lawyers now encourage lenders of an ad hoc group to sign a cooperation agreement. Of course, the cooperation agreement itself is often viewed by lenders as a sign that a non–pro rata liability management transaction is in the cards, and it may cause lenders excluded from the coop group to sell their loans.
Private Credit v. Syndicated Loan Restructurings
A borrower will necessarily have more restructuring options when it is negotiating with a single or a few lenders as compared to potentially dozens of unaffiliated lenders. As a practical matter, it is easier to implement an out-of-court restructuring, maturity extension, or payment-in-kind (“PIK”)/defer cash interest—or any other transaction implicating “sacred” rights (i.e., amendments that require the consent of all lenders instead of just Required Lenders)—if only a few lenders need to consent. Further, given that private credit is a relationship business, the borrower/sponsor may feel more comfortable engaging in restructuring/recapitalization negotiations or sharing information with lenders far earlier than they would with respect to a syndicated loan facility. The private credit lenders are likely to be aligned with each other on a general restructuring philosophy well before making the loan. In contrast, in the syndicated loan market, different lending vehicles have different strategies (e.g., compare a CLO manager with a loan-to-own hedge fund).
Finally, and most importantly, given the relationships that private credit lenders typically have with each other—which can be leveraged as part of originating and documenting the loan and later in connection with any subsequent liability management or restructuring transaction—non–pro rata liability management transactions among private credit lenders are rare. Such transactions often divide a single class of lenders into winners and losers, which may eliminate as viable options a balance sheet restructuring/recapitalization effectuated out of court or via a prepackaged Chapter 11 plan. In a worst-case scenario (e.g., Serta, Robertshaw), expensive intercreditor litigation among the “winners and losers” may reduce recoveries for all stakeholders, as the incremental cash costs of such litigation are significant.
That being said, private credit is not all a bed of roses. The same dynamics that add restructuring optionality to private credit—fewer lenders, lender/sponsor relationships, lack of price discovery and trading—may result in more “can kicking.” Further, lack of trading and price discovery also mean less liquidity, which, as Jamie Dimon recently suggested, may create additional downside risk in an economic downturn. Finally, while aggressive liability management transactions may create more restructuring costs and reduce options on the back end, they present the sponsor and borrower with significantly more opportunity to capture debt discount, which reduces leverage and increases equity value.
