Before the onslaught of Covid-19, when the markets were afloat, lenders gave up asking for protections in their loans. Now, there are signs that the situation is getting even worse, according to PitchBook’s third quarter report on private equity markets.
Some recent transactions contain unusual terms or conditions that allow loans to be transferred to a new buyer in the event of a business sale, increasing the possibility that the lender will not be reimbursed, the research firm found. This is not normal during a recession.
“While this provision often makes the business more attractive to a potential buyer, it does so by removing the rights of the lender,” according to PitchBook. “While many recessions see lenders assert their power and implement additional covenants and protections in new issues, we may be seeing a shift in the norm with this new covenant easing language.”
Lenders’ willingness to reduce their demands on borrowers can be attributed in part to the Federal Reserve’s actions to support credit markets in March and signals from the central bank that it will keep interest rates low for many years. In other words, there is plenty of money for everyone.[II Deep Dive: Barings’ Jonathan Bock Breaks His Silence. Investors Should Listen.]
Although transactions are expected to resume later this year, lenders have also had fewer transactions to fund and there has been little new issuance in the leveraged loan market. According to PitchBook, 3,444 private equity deals worth $453.2 billion were closed in the United States during the third quarter. This represents a 16.2% drop in the number of transactions and a 20.6% drop in value compared to the same period last year.
All of this has prompted private equity firms to issue loans for dividend recapitalization, a practice that typically proliferates during good economic times, not recessions. In a dividend recap, private equity firms take on debt to pay dividends to their sponsors and other shareholders. It is a controversial practice of accumulating debt on a business simply to pay the owners, not to access cash for growth or to reserve for emergencies.
Nearly 24% of capital raised in the US loan market has funded dividends year-to-date through the first half of September, according to data from S&P Global Market Intelligence cited in the PitchBook report. Over the past two years, less than 4% of loans on average have been made to facilitate the dividend recap. “While activity would be confined to higher quality borrowers, it still signals a recovery in some parts of the market, while other segments are reeling,” the authors wrote.
PitchBook also expects fundraising to get “feverish” by the end of the year, after a modest start. Much of the activity will be dominated by large companies and technology funds. “The current climate, where LPs are forced to conduct due diligence via teleconference, continues to favor established managers,” according to the research. But the company said investors may turn to smaller managers next year, even if the pandemic continues.