As companies adapt to the current circumstances, investment funds are dealing with a drop in both portfolio valuations and liquidity levels for the organisations they fund. Chris McLean explores the consequences for leveraged funds who may be at risk of breaching covenants in their own debt facilities at fund level.
With every business adapting to lockdown, many companies in a fund's portfolio will be looking for flexibility in their repayments. Examples include deferring interest payments, rescheduling amortisations or switching cash interest to payment-in-kind interest, all of which will result in delayed income for the fund.
In addition, many companies may require additional liquidity that might not be available from existing creditors. Investment funds that are over-exposed to industries being particularly hard hit by the current lockdown will be under most pressure, including oil and gas, hotels and hospitality, gaming and leisure, retail and consumer transportation sectors.
Leveraged investment funds
However, many GPs have, themselves, borrowed at a fund level. Leverage may be used for many reasons, including boosting returns, funding a commitment, or as a bridging facility.
According to Debtwire, around half of the European direct-lending market uses leverage on at least a portion of their funds1. This, potentially, has a direct consequence on how much flexibility GPs are able to offer their own portfolio companies in terms of repayment deferrals or interest capitalisation. Offer too much, and it could put the fund at risk of default on its own loan documentation due to the reduction of cash inflows.
In addition, with portfolio valuations falling, it is important to monitor whether covenants agreed with a GP's lender are at risk of being breached, putting plans in place to mitigate such a breach. For example, some leveraged investment funds may have LTV covenants, or be committed to maintaining a minimum net asset value (NAV).
Relationship between GPs, LPs and leverage providers
With leveraged investment funds potentially at risk of breaching their own credit facilities, it is important to fully examine what options GPs have to renegotiate with their own lenders. Some lenders could have collateral over a limited partnership's (LP) un-called capital commitment. In an enforcement situation, a big concern for GPs would be the prospect of their lenders speaking to their LPs. This would be this be extremely undesirable for GPs and LPs alike, and potentially affect future fundraising potential.
According to Debtwire, many GPs are avoiding conversations with their own lenders for fear of triggering a revaluation of their portfolio, which in turn, could prompt a lender to call for a repayment on some of the loan or the sale of assets2.
Anecdotally, lenders themselves are currently showing flexibility. It is not in their interest to take over a GPs portfolio themselves, but how long will this flexibility last?
The challenge of reliable portfolio valuations
Debt investments have always presented unique valuation challenges as readily available market prices do not always exist, particularly in the direct-lending market. This has become even more difficult in the current economic backdrop as valuations may be based on rapidly changing underlying assumptions. All of this makes it harder for funds to assess the fair value of the loan portfolio.
Given the uncertainty demonstrated in the public markets, measuring the fair value of investments will require even more analysis. Management need to make sure that any cashflows driving valuations are probability adjusted. How are value drivers impacted by the coronavirus epidemic; for example revenue, cost, growth, competition? These value drivers should be assessed for short-, medium- and long-term impact. There is also the key question of how much weight should be placed on market transactions during public market volatility. Ultimately, understanding the credit worthiness of borrowers is crucial when assessing value.
It is essential that GPs undertake liquidity forecasting. If liquidity stress indicators are being triggered, management need to understand the size and impact of any shortfall and ensure that contingency plans in place. Any previous contingency plans may well need to be re-assessed in light of recent market conditions.
Companies financed by funds will also have their own liquidity challenges. Can they access additional liquidity from alternative creditors? Many direct-lending funds may be concerned that, if companies raise new debt, it brings a risk their own security could be diluted. Managers should also consider whether portfolio companies are eligible to access any of the government loan schemes that are available.
LPs could also have their own liquidity concerns, which would have a knock-on effect for GPs. A survey by Campbell Luytens of more than 150 LPs, published on April 4, found that 31% were concerned about liquidity3.
The private credit market, which developed after the 2009 financial crisis, is being tested for the first time in a serious economic downturn. GP capital calls have increased, with an Institutional Limited Partners Association survey in late March finding that 49% of respondents said calls have increased somewhat, while 9% said calls have increased dramatically4.
Is there a possibility that some LPs could default on their capital commitments? Certain LPs may find themselves overstretched or simply unwilling to fund capital calls at this time. Should an LP default, this could be particularly problematic where lenders have bridged capital calls from LPs. Even if a fund has not defaulted, the value of the lender’s security may have diminished; will the lenders want recourse to the fund’s portfolio assets?
Funds that do require further financing to weather this storm may well have to approach lenders for bridging facilities. At this time, according to one mid-market participant focused on funds finance, successful financing will rely on the quality of the GPs and their proven ability to ride out economic cycles, together with their relationship with LPs.
The coming weeks and months will be difficult for funds, even with the easing of lockdown restrictions. As well as the issues outlined above, on a more operational level, many smaller funds will not have work-out teams to enable them to execute any restructuring required by companies within their portfolios. To navigate through this period, clear and regular communication to portfolio investments, LPs and lenders is paramount.