Private Credit: Worst Reckoning since '08 | Industrial Deal
Private Credit: Worst Reckoning since '08 | Industrial Deal
Weekly Digest, 9/29
Happy Sunday!
Today we're diving into a Bloomberg article that explores the looming reckoning in private credit. This topic is timely as Apollo Global Management has once again made headlines, this time announcing a partnership with Citigroup. For those who may have missed it, we recently covered Apollo's venture into public markets with private credit offerings:
This week’s deal is an industrial sale-leaseback. We asked AI to stress-test the exit cap rate (with some prodding) and share an IMPORTANT privacy tip - with instructions on how to change your settings in ChatGPT.
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What to Read
Citigroup has announced a $25 billion partnership with Apollo to enter the private credit industry, aiming to lend to private equity groups and low-rated US companies. The partnership will leverage Apollo's credit business expertise and Citi's client relationships to originate and fund loans over the coming years. The two groups have agreed to finance at least $25bn of private equity and corporate loans over the coming years, hoping to hit $5bn in the first year.
The table below (from Prequin) illustrates the risk/return profile of private credit funds (vintage years 2011-2017):
Meanwhile, Jae Yoon, CIO of New York Life Investment Management, warns that the private credit market is facing a "reckoning moment" and potential difficulties not seen since 2008 due to inflation and recession risks.
Yoon points out that the private credit market has been boosted by fiscal stimulus and booming markets, but this may be ending, leading to a significant dispersion between well-managed firms and unnecessary risk-takers.
Among other challenges cited: including excessive competition, loosening borrower restrictions, and declining recovery rates.
Let us know in comments if you think Mr. Yoon’s dire warning is warranted!
Deal or No Deal?
This week’s deal is a sale-leaseback industrial property. For those unfamiliar with this structure, here's a quick primer: When private equity firms acquire companies, they often employ a strategy of selling the company's real estate assets and simultaneously signing long-term leases on those same properties. Please remember, the deal is presented as an education exercise, and all relevant information has been changed to protect the identity of the sponsor.
This deal is a very typical sale leaseback: tenant (in business for several decades) signed a 20 year lease with 2.5% escalators and several extension options.
Single tenant NNN deals are easy to grasp, and typically present three major risks:
Vacancy and rent escalators. This deal assumes an annual rent escalation of 2.5%. If tenants vacate, default, or there is an unexpected economic downturn, rental income may disappear, leading to cash flow problems (and inability to cover debt payments). Being in a tertiary market, vacancy could end up lasting 12 months or more.
Leverage. The deal involves substantial leverage with a 6.75% interest rate and a Debt Service Coverage Ratio (DSCR) that starts at 1.38 and rises to 1.60 over the holding period. In the unlikely event that the tenant vacates, not only would investor cash flow disappear, but the operator could call capital to cover debt payments. On the positive side, the debt is amortizing.
Exit Cap Rate. Market conditions at the time of exit may cause the exit cap rate to increase beyond the projected range (it’s underwritten for 7.5%), which would reduce the value of the property and, consequently, the investors’ returns. This is where AI can help immensely: stress-testing for certain assumptions is not easy unless you have sponsor’s pro forma in Excel.
Learn more about cap rates here:
An important diversion: if you are using a free version of ChatGPT (or any other LLM, for that matter) - you need to remember that the model will use the information to upload to train itself on the topic. Here’s how to change your privacy settings:
So let’s see what ChatGPT can do with cap rate sensitivity. To start, you ALWAYS want to confirm the following:
structure of the deal;
capital stack;
debt terms;
waterfall and fees.
Sometimes, you will have to isolate the relevant information: the easiest way is to upload the page with the pro forma separately.
Prompt: “stress test exit cap rate assumptions and show investor-level IRR, given the waterfall”
Please keep in mind - this isn’t 100% accurate, but for our purposes, we don’t need it carried to the third decimal place. We are screening for obvious ways the deal can “break”, and to see how wide the margin of safety is.
What do you think? Is there enough margin here? Is the deal easily breakable? Vote below.
As to Mr. Yoon's warnings, IMO it makes sense to be skeptical of all scary narratives. Those who push them usually have an incentive other than expressing objective judgement. Still, after 10 years (or 20) of ridiculously low rates, capped by ZIRP and lots of convenant lite loans, one has to think that a lot of firms are swimming naked. Someday we will find out who.
“The recovery rate is coming down, there are too many players and too much money chasing deals and covenants are getting lighter and lighter,” Yoon said, referring to a loosening of restrictions placed on borrowers. “The last 15 years should not be repeated in the next five to 10 years.”
While Yoon emphasized that the risk was not of an “Armageddon” level meltdown, he said the flood of capital had led to too much debt concentration.
From what I understand covenants have been tightened over the last 10 years so if they loosen now that is to be expected. I could not find any mention of a base rate that applies a recessionary time to it. The Cliff Water index show for all public BDCs during the GFC the average draw down was about 6 to 8% and recovered within 12 months. During the GFC yields/dividends did NOT drop. Some long term private lenders such as Alpha ha had ZERO losses going back before 2004 and default rates that are 50% of the market average. Per Stephen Nesbitts book/Cliff Water, the top quartiles of BDCs way out perform the average and the lower quartiles. This is measured by thier annual yield/dividend, annual defaults, annual recovery rate, annual losses. Several of the CEOs of the TOP private debt companies say terms are tightening and there will be more defaults. Lending at a 40 LTV on a company that is valued at only 11 X EBITDA (think a 9 cap CRE property) with the right to step in if the financials change from month to month.