The private debt market returned surprisingly quickly in the second quarter, after a short but intense dark period after COVID-19 hit, but much remains unknown as the year winds down, private lenders said in a global advisory firm Dechert LLP webcast. 

Having spent much of 2019 raising funds, private lenders were in a strong position at the start of the pandemic, so credit was available to help companies weather the uncertainty. As with banks, private lenders were focused on replenishing companies' depleted revolving credit lines and otherwise making incremental loans.

Although private credit was in a strong position, the volume of drawdowns on revolving lines hit some lenders hard, especially compared to banks, which were better able to handle borrower demand, in part because of their lower cost of capital.

"There was a bit of stress from some unanticipated drop in the revolver and the extent to which that occurred," said Kristine Jurczyk, co-head of Vista Credit Partners. "That had forced some people on the private credit side to be out in the market generating liquidity in a suboptimal environment."

Some firms were well-positioned to leverage the sudden downturn by providing rescue loans or, through their affiliates, equity infusions to hard-hit companies, but the window closed surprisingly quickly. Before the second quarter concluded, markets were improving. 

"When we saw this opportunity present itself, we did a quick raise [for] our new dislocation fund," said Cade Thompson, a partner on the credit side of equity firm KKR. "The window was probably not open for as long as folks would have wanted. We were able to deploy a decent amount out of that and deploy a decent amount out of our private equity strategy as well."

Among the deals KKR closed was a $500 million purchase of newly issued convertible preferred stock for U.S. Foods. 

Thompson said KKR would have liked to do more of those deals, but markets stabilized quickly. The "dealmaking machine wasn't fully ramped at that point," he said. "To step in and do some of these rescue financings in the form of a preferred, or what have you, was the flavor while it lasted."

Busy summer

Since the late second quarter, both primary and secondary markets have functioned relatively well, and credit providers are now hunting for new deals, mainly for companies that stand to benefit from a post-COVID environment, the lenders said. 

Business was booming for private lenders over the summer, more in the United States than in the United Kingdom or Europe, but still relatively well even across the Atlantic. 

"Europe is probably a little behind the penetration curve of non-bank lenders' share of the market," said Daniel Sinclair, a partner on the lending team at Ares Management. 

Even so, larger private capital firms have been able to pick up business that might otherwise have gone to banks.

"Your scaled operators with capital and resources, in terms of team size, have been able to take advantage of lenders perhaps being distracted by what's on their balance sheet," he said.

Banks, particularly in Europe, have also focused on government-supported loans, leaving alternative opportunities, including for leveraged buyouts (LBOs), to the private side. 

"Government-supported loans have taken resources away from potentially supporting LBO deals, so that's certainly been a factor over the summer across Europe," said Sinclair.

Rise of portability

In a shift, lenders say they're seeing more deals offering portability, a deal structure that enables loans to stay with the company after it's acquired rather than replaced with other financing. 

The deals can help equity sponsors sell their portfolio companies quickly and buyers can find the arrangement attractive because it simplifies the purchase, but critics say the benefits are debatable; they can leave buyers with debt that's not optimized for them. 

"To step into exactly the same capital structure, with the same covenant profile, the same term ... [that's why] you get the debate," Sinclair said.

Until this sudden interest in portable deals this summer, the structure hadn't been seen much in recent years, although a deal KKR completed a little more than three years ago with investment banking advisory firm Evercore was portable. 

That deal was attractive in part because of Evercore's strength, including the quality of the credit and the recent performance of the business, Thompson said. 

Jurczyk said she prefers deals not have the structure. "To the extent a loan does get ported over, it means the market has moved against you," she said. "So, for that reason, we don't love it."

Junior debt competition

The lenders said there's not just competition in the market for first liens; the market for syndicated second liens is also strong.

"We've continued to see increasing amounts of evidence [of] a deep and functional market for syndicated junior capital," Thompson said.

Syndicated accounts are on the hunt for a junior component, he said, "to strip along the first lien and juice the return."

KKR was recently involved in a junior deal with contact lens retailer 1-800-Contacts. 

"There certainly were private solutions available," he said. "It was just our view that, given the speed of velocity to market … and the demand we saw in the syndicated marketplace, [it was] going to be a more optimal outcome for us as an issuer."

Year-end uncertainty

The big question for private capital as the year winds down is the amount of disruption ahead, lenders said. 

COVID-19 is resurging, and both the U.S. presidential election and Brexit deadlines in the U.K. could create vast uncertainty.

"My outlook is a little more proactive than defensive than it would have been in April," Jurczyk said. "I'm better set up from a mindset perspective as well as having the house in order to take advantage of the volatility. But I don't think we're out of the woods."