When Jamie Dimon mentioned cockroaches lurking in the credit market last fall, the comment itself spread like an infestation. It was picked up by business news outlets everywhere.
In a conference call back in October with Wall Street analysts, Dimon, the longtime CEO and chairman of JP Morgan Chase, casually warned, “When you see one cockroach, there are probably more.” He was answering questions about the collapse of First Brands and Tricolor, two U.S. auto sector companies, and risk in general in the private credit market.
His words were consistent with his oft-stated belief that a cyclical downturn, if or when one occurs, could uncover further problems for private lending. “Everyone should be forewarned on this one,” he said.
Yet, this month, news broke that JP Morgan is immersing itself further into private markets with a new advisory team to help companies attract private capital.
There has been a lot of chatter in the last few months, a lot of concerns.
Erica Barbosa Vargas, director, private markets, Eclipx Family Office
With private credit having grown into a sector trillions of dollars in size, lending to the kinds of small and mid-sized businesses that often don’t qualify for bank loans, private markets remain a key focus of the financial world.
So, what are family offices doing in the wake of Dimon’s remarks?
“There has been a lot of chatter in the last few months, a lot of concerns,” says Erica Barbosa Vargas, director, private markets, at Eclipx Family Office, the single-family office for the Trottier Family Foundation in Montreal.
Private credit’s complexities go well beyond basic maintenance covenants, such as borrowers keeping to a certain level of debt to EBITDA.
“It’s interesting when you look at the entire spectrum, because it has become many different things, from direct corporate lending to asset-backed financing to distressed situations, other special situations, mezzanine finance, etc. It depends on the type of investor. Different investors will have different objectives,” Barbosa Vargas says.
Given these competing interests, “this is one area, one asset class, where we typically try to work with partners who have been around for a very long time and have gone through different cycles, so we are able to see their behaviour during downturns, during difficult situations, etc.,” she says.
Tighter bank regulations in the wake of the Great Recession helped spur private lending. Yet, of course, the calculation behind a loan’s terms can include myriad factors, from the size and health of the borrower’s business to the level of oversight and documentation that the lender demands from the borrower. And if the company is backed by private equity, what is that financial sponsor’s track record?
“Then we look at their ESG policies,” says Barbosa Vargas. On the one hand, it’s about “having some responsible covenants in place to ensure that your investment is protected, but you also want to balance that with some ethical principles.”
The idea, she says, isn’t to act like a furniture store selling zero-per-cent financing, only to pull the rug out from under a customer if they can’t make a payment.
However, it’s also the case that making numerous amendments to a loan’s covenants, in order to help a borrower pay back a loan, may be a warning sign, too, say market watchers.
This is one area, one asset class, where we typically try to work with partners who have been around for a very long time.
Erica Barbosa Vargas, director, private markets, Eclipx Family Office
“I think fundamentally we do believe, and I personally believe, that you can strike a good balance between protecting your investments and then also maintaining good practices from a more ethical standpoint,” Barbosa Vargas says.
Ting Xu, assistant professor of finance at the University of Toronto’s Rotman School of Management, notes that over time, covenants have been increasing, “which is kind of opposite of what you would predict if you see an increase in competition” among lenders.
As he explains, it all goes back to the fact that loans depend on a long list of factors. A “debt contract is always a combo of interest rates, covenants—secured or not—maturity and a bunch of other things.” Covenants are just part of the equation.
One strategy for lenders can be to shift their focus to smaller mid-sized companies, where they might find a more lender-friendly environment in which they have more control over the covenants and loan negotiations, as opposed to “arm’s length, high-yield bonds or syndicated loans, which tend to be more covenant-light,” Xu says.
Goldman Sachs noted in a commentary last May that private lending portfolios lean toward defensiveness and tend to avoid cyclical companies. Instead, regular cash distributions to investors are the draw. Private credit may not have the potential gains of equities, but it provides a steady yield, or so investors hope.
Similarly, Xu notes research indicating that one of the biggest attractions for investors is “to have access to stable income flows—not necessarily because they want to take on more risk, or that they think this market is more profitable, or for diversification.” Relative stability is again the selling point, although the sector remains opaque, and regulators are said to be demanding more transparency, as are risk-averse investors.
One concern is that debt investing is being marketed as a bond-like, lower-risk product.
“No,” says Barbosa Vargas at Eclipx. “There is a lot of risk involved. If anything for us, it falls under the alternative asset classes, and it’s very much in the same alternative families as venture capital, private equity and that entire group.”
So, how then does Dimon’s remark translate in the workaday world of covenants and debt investing? As another market commentary from JP Morgan argued, “the risk lies with bad actors, not the asset class itself.”
Riley Phillipson, chief investment officer and portfolio manager at Access Family Office Corp. in Mississauga, says that, in general, “a great deal of time and effort across the industry has been devoted to reducing portfolio volatility, and the growth of private credit has been a natural outcome of that.
“That dynamic has driven record amounts of capital into the asset class broadly, with some estimates suggesting private credit is now larger by assets under management than the entire public high-yield bond market,” he wrote in an email. “It is an enormous pool of capital.”
He adds: “As with any asset class, however, there are only so many attractive opportunities available at any given time. When too much capital is pursuing a limited number of high-quality deals, underwriting standards can be pressured, and risks may emerge that are not immediately evident.”
Guy Dixon began his career at Dow Jones Newswires in New York before joining the Globe and Mail, covering financial markets, business news, the arts and other topics over the years. He has written for the CBC and The Walrus among other publications.
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