Special opportunity funds take advantage of the stress through loan to own

Regulators may be granting forbearance from recognizing loan impairments to keep credit flowing, but European banks’ large first-quarter loan loss reserves still exceeded analysts’ expectations.

HSBC took a $3 billion charge for the quarter and could reserve from $7 billion to $11 billion for loan losses for the whole of 2020. Barclays took a £2.1 billion impairment saying that low credit losses so far simply do not reflect the impact of the coronavirus Covid-19 pandemic. BBVA took a €2.6 billion provision, Societe Generale €820 million, and Deutsche a much more modest €506 million.

Euromoney is surprised that bank analysts are surprised. We are, after all, facing the swiftest and steepest economic collapse since the great depression and at a time of record high private and public debt to GDP.

Startling

Far more startling is the low expectation for defaults among high-yield issuers implied by market pricing at the end of April – perhaps 10% for US issuers and as low as 6% for European issuers that tend to have higher credit ratings, according to analysts at Deutsche Bank.

Those optimistic expectations reflect the swift support from central banks and state guarantees on loans to tide companies through what they hope will be a short shutdown.

Private equity funds, like doctors in an intensive care unit, will be forced into triage 

Few financial market participants seem capable of acknowledging that the virus might be uncontrollable and governments incapable of bailing companies out indefinitely. Highly leveraged companies can only survive for so long with supply chains broken and customers not spending.

Their owners, the private equity funds, like doctors in an intensive care unit, will be forced into triage: choosing which might be saved with injections of fresh equity and which should be switched off and left for lenders to fight over whatever collateral can be sold.

Behind the scenes, the drama is already quietly starting to play out. Private equity sponsors were quick to require portfolio companies to fully draw their revolving credit facilities. But such heavy drawdowns can spring financial maintenance covenants that require equity cures.

Limited partners are looking through their fund agreements to check how much of their committed capital can be called to support existing portfolio companies. Limited partners report some private capital raising in the last couple of weeks by companies that might look like potential winners. But there is only limited appetite for this.

Negotiations

Lenders are studying their covenant packages and attachment points as negotiations with sponsors loom.

Many of these lenders are not banks but investors and increasingly prominent among these are private equity managers’ own debt and special opportunity funds. These have been buying debt at deep discounts to par in a thinly traded secondary market. They are also offering to buy preferred equity at high yields from selected companies they think will survive while offering new debt and credit facilities to those that may not, seeking to lend on a secured basis and so structurally subordinate existing lenders.

They want the strongest debt-like protections they can get and the highest equity-like returns.

Special opportunity funds, led by the likes of Apollo, may have different limited partners than their regular PE funds. They may yet wrestle away companies that could do well in a recovery from rival private equity owners.

The loan-to-own game has already started.