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In COVID-era test, private credit proves its mettle vs. leveraged loan market

Private credit providers had a chance to show their true colors this year.

Many of these lenders touted themselves as champions of Main Street, the small and midsized companies that commercial and investment banks supposedly turned away from after the credit crisis in 2007. They claimed to have a flexibility that banks lacked. They said they could underwrite and hold even large loans.

In March, with the COVID-19 pandemic worsening, the syndicated loan market — private credit providers' main competition in the business of lending — effectively shut down.

To some dealmakers and yield-hungry credit investors, it was the moment they had waited for. Private equity firms had amassed huge stores of capital to invest. But who would finance their deals? As financial markets plunged, banks turned cautious.

Private credit providers, too, had issues, though. Some of these lenders were juggling problems across their portfolios. Many of their existing borrowers faced covenant violations as revenue streams stopped. Some borrowers needed covenant holidays or switched to payment in-kind, or PIK, interest. Lenders saw their share prices tumble and financing sources had become more stressed.

Some private equity sponsors called lenders to say they could not meet interest payments. The meaning of diversity in portfolios was redefined as borrowers across myriad geographies, sectors and business models buckled under pandemic shutdowns.

Airbnb Inc. was one company whose business model was upended by the crisis. Travel ground to a halt. Skepticism about staying in strangers' homes increased. With uncertainty high, Airbnb responded with plans to cut 1,900 employees, or 25% of its workforce, citing travel restrictions from the COVID-19 pandemic. But management still had huge ambitions.

The company needed to move quickly. No one knew if financing markets would go away completely. Would private credit providers step up?

Speed to the rescue
With Airbnb in dire need of quick cash, private credit providers were willing to step up. In the end, Airbnb entered into $1 billion first-lien and $1 billion second-lien loan agreements.

"Private credit was good for speed. They could do it without ratings because of the name. Not having to get a rating allowed them to get to the market one or two days faster. The company also wanted to protect its information," a person familiar with the transaction says.

With the syndicated loan market, a borrower's financial information is typically released to a much larger group of investors for consideration, increasing chances of sensitive data escaping.

Private credit providers who were willing to step in when the situation looked bleak were rewarded. Airbnb shares more than doubled on the first day of trading on Dec. 10 after an IPO on Nasdaq.

As for lenders, Silver Lake and Sixth Street provided a second-lien loan due July 2025 at L+1,000, with a 1% Libor floor. The second-lien loan is subject to a make-whole clause until then. Airbnb issued equity warrants as part of the agreement, entitling them to 1.25% of the company.

The company also received a first-lien loan due April 2025, which is subject to a make-whole premium. Pricing is L+750, with a 1% floor. It was issued at 97.5. From September 2020, the loan amortizes quarterly at 0.25%.

More than 20 lenders participated in the first-lien loan, including Silver Lake, Sixth Street, Oaktree, BlackRock Inc., Eaton Vance Corp., Fidelity Investments, Apollo, Owl Rock and T. Rowe Price Group Inc., sources said.

Wind at their backs
During this test, private credit validated many of its advantages.

"They got an 'A,'" says Bill Brady, head of the alternative lender and private credit group and member of the special situations group at Paul Hastings. "Especially when there was a deep relationship between the lender and the sponsor."

Airbnb may not necessarily be typical of the borrowers that some private credit providers cater to, however.

In recent years, lenders have piled into the market to provide financing to healthy companies with a track record of generating annual EBITDA of $15 million to $100 million, especially ones owned by private equity investors. But even for deals outside this realm, the advantages of a loan from a nonbank lender still apply.

"Private credit proved it's a more flexible asset class. While many banks were on pause, direct lenders were open for businesses. Direct lenders showed themselves willing to put money to work," says Dan Lee, partner at Comvest Partners.

In contrast to the syndicated market, private credit lenders generally commit to loans at prescribed terms, protecting borrowers from a higher interest rate if demand in the syndicated loan market changes before a transaction closes.

Another deal that succeeded at the peak of coronavirus-related financial market volatility was a $237 million unitranche loan to software provider Command Alkon Inc. for a buyout by Thoma Bravo.

Ares Capital and Barings Finance were lenders. Barings BDC added a $9.9 million first-lien loan priced at L+825 to Command Alkon to its investment portfolio in the quarter ended June 30.

Lenders are often willing to provide structures that the syndicated loan market typically does not like, such as a delayed-draw term loan. These are typically unfunded at close, but a borrower can access them later. Although that market cooled due to pandemic-driven uncertainty, it has come back.

Insurance distributor Integrity Marketing Group LLC was the deal that kickstarted this market with the placement in the third quarter of a DDTL priced at L+625, with a 1% floor.

In addition to new investments, private credit showed its utility as amendments and workouts increased.

"During the early months of the pandemic, I think many found that managing troubled credits as a sole lender or with a club of two to three lenders was significantly easier and more efficient than doing so with larger, unwieldy lender groups whose constituents tended to approach credit from a variety of different angles," says Garrett Ryan, head of capital markets at Twin Brook Capital.

New trends, new year
Despite the overall stamp of approval for the asset class, the pandemic showed existing ways of thinking may no longer apply.

"Lessons learned in 2008-2009 were put into practice. We didn't see nearly as much of a knee-jerk reaction," says Mark Birkett at M&A and debt advisory firm Livingstone. "Many borrowers defaulted, or were about to, during this period. That's what private equity firms worry about most because it provides lenders with a broad range of remedies, some of which can be very painful."

One immediate reaction to the crisis was the shrinking of hold sizes and providing loans as 'clubs' as lenders opted to reduce risk to any one borrower. But recent months have seen a comeback of some larger loans.

Going forward, lenders of private loans may be less willing to extend large revolvers. At the peak of uncertainty, many borrowers drew down the facilities to enhance liquidity, even when they did not have an immediate need for the cash. This was a headache for private credit lenders, who count on borrowers drawing them at different times.

The advantage of lending to companies backed by private equity sponsors was evident, market sources say. Lenders say they found support from private equity sponsors for good businesses. With many shared deals between lenders and private equity firms, there was an incentive from both sides to find solutions.

"Private lenders are being more flexible than banks would have been," says Scott Turley, vice president of product evolution at Broadridge, which provides software used by private debt providers to manage portfolios. "A lot of loan principal payments were not made. For companies that came under stress, there were opportunities for lenders to step in."

Perhaps the most valuable insight from the year will be about character. This could govern the choice of which business partners to work with in the future.

"By the end of the second quarter, in many instances, lenders had a range of options at their disposal providing them with varying degrees of leverage," says Livingstone's Birkett. "By not abusing this, they may have engendered goodwill from sponsors. The hope from lenders is that if, in the future, there's a jump ball when selecting a lender for a new deal, the sponsor is going to go with the one who didn't abuse that leverage."