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The Private Credit Market - An Overview

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The Private Credit Market - An Overview

This program will provide a general overview of Private Credit for attorneys who hope to gain a better understanding of this popular asset class. Attorney Gabriel Yomi Dabiri, Co-Leader of Polsinelli's Private Debt and Cross Border Finance team, will take a deep dive into the recent rise of Private Credit, what characteristics differentiate Private Credit, and the state of the Private Credit market. This program will also discuss the chronology of Private Credit deals and attempt to forecast the future of the Private Credit market.

Transcript

Hello, everyone. My name is Gabriel Yomi Dabiri. I am the private credit and cross-border finance leader at Polsinelli. And today I will be leading a class on the private credit market. So this will be a general overview of a growing asset class that a lot of people have gained a lot of interest in, particularly in the mainstream business news this year in particular. So today we'll walk through a few learning objectives for those who are seeking to learn more about the private credit asset class. So what are our what are our learning objectives today? We will first define what constitutes private credit. We'll then move on to understanding the context in which this asset class came to prominence. We're going to differentiate private credit from other asset classes such as private equity. We're going to identify the primary players in the private credit market. We'll then move on to discuss the chronology of a deal and then we'll just have a brief conversation at the end of the program to discuss the future of private credit and where we go from here. After the really quite extraordinary run up that we've had leading up to today. So what is private credit? Well, private credit is an alternative to traditional financing that you would normally receive from a bank like a Goldman Sachs or a JP Morgan. Although there are some exceptions to that which we'll get into later. It's lending based on privately raised capital rather than on consumer deposits. So this has really important fundamental implications for how the space is regulated, which is different from a traditional bank or financial institution. This is also tends to be balance sheet lending, meaning when a loan is made by a private credit lender, they hold it on their balance sheets through to duration, and they are not necessarily relying on the economics of selling that loan into the secondary market. So it's usually not syndicated, which is the process. Syndication is the process of selling loans into the secondary market. So where do these transactions typically occur? Well, private credit market originated in the United States and the United Kingdom, and that is where the majority of private credit activity currently occurs. Although that is changing very quickly, It's become very popular in other parts of the world, such as Canada, Japan, throughout parts, other parts of Asia. Um, but right now the majority of private credit deals currently occur in the United States and in the UK for now. So let's move on to discuss the growth of private credit, which has been really quite extraordinary. You can see here we have a graph kind of setting out what the appetite for private credit has been over the course. I guess it runs from 2000 until now. The growth really began to start picking up during the global financial crisis for reasons that we will explain. But this happens to be the first year that private credit has taken over the broadly syndicated loan market, which is a term for the traditional lending market that you would get from a traditional bank. So that's a $1.5 trillion market. Certainly north of $1 trillion for the broadly syndicated loan market, which again includes traditional lenders that you would think of JP Morgan, Goldman Sachs, Morgan Stanley, Bank of America. And it's now moving towards private credit, which is, you know, commercial or business loans made by privately raised capital. So how did this happen? Why are we in this position now where everybody seems to be talking about private credit for the first time, even though it's been a rather large asset class for some time? It seems to have snuck up on the business community. You know this as an asset class and the popularity of it, and a lot of people are looking to learn more about it. Well. A lot of this dates back to the global financial crisis, the GFC back in 2008. As many of us will remember or lived through and experienced during that period of time, the economy fell into a very deep recession. Between December 2007 and June of 2009 due to the collapse, or at least triggered by the collapse of the subprime loan market. Confidence in the financial market collapsed during this period of time. So it was called a credit crunch and nobody could really trust the numbers on banks balance sheets. And so the primary thing that was determined was that banks were inadequately capitalized. They didn't have enough capital kind of in their reserves to continue making the loans that they were making and to service the existing loans that were outstanding and were quickly learning. We're not very good loans to have been made in the first one first place. This leads to these banks who stopped trusting one another to be in a position where they're unwilling or unable to continue lending. And what was politically very unpopular. These banks were bailed out in the form of 150 billion, $15 billion from the Treasury alone. But the overall bailout price tag was significantly more than this. As many of us who lived through this period can remember. Still in 2009, bank lending from the four biggest banks decreased. So this is Bank of America, JP Morgan Chase City and Los Fargo. This lending decreased by 15%, which is an extraordinary amount of contraction in a short period of time. And then consumers are spending less money, leading to further losses by businesses exacerbating the economic downturn and putting a lot of businesses out of business. So during this period of time, 2.5 million businesses ended up closing and 8 million Americans ended up losing their jobs. During this period of time. I was starting my career as an attorney at this time, and a lot of lawyers lost their jobs during this time. A lot of lawyers who are my vintage or older, even some younger ones, will remember this very vividly. And so. What tends to happen in environments like this is you're going to get new regulations to try to prevent a repeat of the events that occurred during the global financial crisis and that led up to the global financial crisis. So you had new regulatory regimes in the US and abroad and the US. You had the Dodd-Frank Act. In Europe, you had the Basel three accord, and all of these regulations kind of work together to significantly restrict the types of loans that could be made, particularly to riskier credits. Capital reserve requirements were increased significantly. All of this resulted in fewer available loans at this time. And again, a lot of these banks were really struggling and they were trying to figure out what their actual position was during this period of time. And so really lending activity came to a screeching halt. And without necessary capital, it just became a vicious cycle with more businesses going under because the banks couldn't lend and the consumers are struggling because they were losing their jobs so they couldn't contribute to the economy. And so it was really, truly a scary time for those who are learning more about this now. But, you know, again, many folks around my vintage remember this period very, very, very clearly. So you then have private credit to the rescue. So yet you're in this scenario where startups, mid-market borrowers and distressed companies are all in dire need of capital. Banks aren't servicing higher risk and higher complexity credits. A lot of people think of higher risk credits is just maybe businesses that have no business being in business or who are engaged in a sort of business that is just inherently like gambling, But that's not necessarily the case. You're going to have credits that are considered risky if it's a startup. You will also have credits that are considered risky if they're in a distressed scenario. And there were a lot of companies that were distressed that were good businesses and were struggling because of the macroeconomic environment and not because the underlying business plan and strategy of the business was not capable of keeping the business running as a going concern. They just needed capital, as most businesses usually do. In this environment, Private credit kind of enters the scene as lenders of last resort. So that leads to what differentiates private credit from other forms of lending. Why is it that private credit was able to lend in this environment when other financial institutions were unable to lend? Well, why don't we go into private credit versus syndicated finance? So private credit funds, they raise capital from investors to originate loans, Right. So they go out to sophisticated investors, which can include universities, pension funds. They aggregate the capital from those private sources of capital, including family offices, wealthy individuals. And then they use that capital in the form of they deploy that capital in the form of loans. So lenders typically, but not always. Called the the debts represented by these loans on their balance sheet. Rather than syndicating the loans in the secondary market. And then with private credit, this allows for greater flexibility in lending terms, since private credit is less constrained by what's considered market. So when you have a broadly syndicated loan market, you are, you know, the provisions need to be readily identifiable. Investors in the secondary market need to have a general idea of what the document is going to look like in order for it to be more liquid in the market, more tradable in the market. Because you have private credit loans that are not relying on, for the most part, that aren't relying on a secondary market to trade the paper, which is another term for these loans. You find yourself then in a scenario where you can have more flexibility so you can have a business with seasonality. You think of maybe a ski resort where, you know, in the winter months the revenue that comes in is going to be significantly higher than in the summer months. And so in a private credit loan, you can kind of draft around that. So the unique circumstances of that particular business, whereas, you know, other forms of lending, broadly syndicated loans, it will be more tradable if the documentation is kind of uniform with respect to revenue expectations over the course of an entire year. So that's kind of a crude example of the difference between the two. But that flexibility in terms of what the terms are in the loan documentation is great for a borrower, right? And it also encourages private credit lenders to really dig in and understand the business. Right? What are the things that allow the business to be successful? What are the things that might impact the numbers but may not necessarily indicate that there's a problem with the business? Let's draft around those things to have a very bespoke loan facility that addresses the very specific needs of that particular business. This is a type of drafting and negotiation that is just easier to achieve in the private credit market and with a private credit loan than what is typically possible in a, you know, a syndicated finance loan or a loan that's going to be sold into the secondary market. So with respect to private credit, historically there has been no marketing of these loans in the secondary market, as I just said. But this may not last. So we're dealing with a very large market now, $1.5 trillion. And there, you know, there was a Bloomberg report earlier this year about the fact that there are some commercial banks, namely Barclays, Goldman and JP Morgan, that are looking to create a secondary market of sorts so that these loans can be traded. And, you know, the jury is still out as to how effective that will be. But there is a movement, at least by some, to try to create a secondary market for these loans. And we'll just have to see how successful that is and how that eventually impacts the private credit market. A benefit to the borrower in the private credit loan is there's greater certainty in the lender in who their lender is going to be for the duration of the loan. Since private credit lenders aren't looking to sell the loan into the secondary market historically or typically, and they're holding it on the balance sheet for the duration, the borrower doesn't have to worry about signing a loan with one lender, with the individuals at that lender being known to the borrower. And you build a rapport and then, you know, the day after you sign the loan, all of a sudden, you know, Bank B comes along or Financial institution B comes along and you're dealing with a totally different relationship. And folks who may not understand the business as well as that initial financial institution that you've been negotiating with. So that that is proven to be a really attractive sell for private credit as compared to a traditional bank loan. As said before, there's more flexibility in the terms and lender accommodations that you can get in a private credit loan as compared to a broadly syndicated loan typically. And then these loans are less likely to have the credit ratings that are broadly syndicated. Loan would have in part because they're not being traded or being held on balance sheets. There is a cottage industry that has popped up and disappeared and popped up again of of organizations that have tried to rate these private credit loans. But in my experience, it's not the sort of thing that I've seen really take hold as a feature of the practice that I'm engaged in, and my team is engaged in that personally. So private, private credit and private equity over the period of time where private equity grew significantly as an asset class, they became more familiar with and attracted to private credit as a means to fund a lot of their deals. Right. There's going to be a certain amount of equity that's put into a private equity deal. But these are leveraged buyouts for for the most part. And so there's a certain amount of debt, a significant amount of debt in many cases that's a component of a private equity deal. And as opposed to operating with commercial lenders, which is still the case, right? It's still a 1.5 or certainly north of $1 trillion dollar market for the asset class when it comes to broadly syndicated loans by commercial and traditional banks. More and more private equity is also looking to private credit as a means to provide the debt component of the deals that they are working on. So what is private equity? Private equity is frequently deployed in M&A transactions and they seek ownership control of the company to manage it. So the idea is you take over, you identify a company that seems to have either management issues or is not fully optimizing the potential for the company. So a private equity fund will come in, you know, take over the company. They'll either have specific industry or sector expertise that they believe that they can kind of make use of. Sometimes they're changing management just to run things in a different way. And then the idea is in a few years, once the company is kind of streamlined and operating more efficiently and profitably, they can sell that business as at a profit. And that is really where the expectation of revenue and the economics comes from. On a private equity deal, private credit is different. There are occasions where private credit lenders will take an equity stake in the business that they are loaning to, but usually it's in a minority position. They may have a board observer seat, but not necessarily an official board seat for the company that they're lending to. And it's really just enough to monitor the company to ensure that at the end of the loan period and during the loan, that that loan is serviced by way of principal interest and fees. Principal if it's an amortizing loan. During the course of the loan and then once the loan is meant to be paid back, that they're going to get repaid, you know, the entirety of the principal and any interest in fees that are due at the end of the loan. So as opposed to private equity where they're looking to take over a business, run the business, make it more profitable and then sell it. Private credit really relies on the interest and fees that are assessed in making the loan in the first place. And to the extent that they're taking an equity stake, it gives them some potential upside if the business improves. But that's not the primary basis for the economics, and they're just looking for steady returns over the life of the loan rather than kind of an explosion of profit and revenue because they've chosen the right business to invest in. So we have a couple of slides here. So again, private equity funds seek to increase the overall value of a company and sell at a higher price than when they invested. But the economics and private credit really rely on stable returns from interest on the loans, maybe a minority equity investment, and then certain fees that are assessed for really undertaking the risk of loaning to that company. But so the allure of private credit for borrowers and investors is, you know, the attractive and stable spreads. Generally, private credit produces yields of over 9%, as you can see by this chart, compared to 4.3% for investment grade bonds. You can look at treasuries, which have been historically kind of between 2 and 4%. High yield bonds, you know, corporate general corporate debt. You know, none of those asset classes in recent times has been able to generate the kind of returns that private credit has been able to generate. And this is the reason why, you know, when you turn on Bloomberg or CNBC or some of these other financial news stations, you're hearing more and more about private credit and people trying to learn more about this asset class. So you might ask, okay, we have an environment where there's a global financial crisis. You have traditional banks that have retreated because they no longer want to make risky loans or are unable to make loans to credits that they and businesses that they view as risky. You have an environment where private credit is not regulated by the same regime that a traditional bank lender is regulated by. So and it's a huge asset class. Well, how does private credit go about mitigating the risks involved in making these loans? Well, private credit funds are able to serve riskier credits and make more creative investments than banks. And this leads to higher returns, right? So because private credit is able to lend to riskier situations than the traditional bank, there's a cost for that, and rightly so. And so the interest rate that you'll get on a private credit loan tends to be more than what you would get on a broadly syndicated loan from a traditional bank. The private credit is also able to invest in a wider variety of companies and assets. Again, kind of a proxy of the increased risk that is possible from a private credit lender's perspective than a traditional bank that's making a loan. But in order to protect themselves. My experience in advising our private credit lenders is there's a lot more intense scrutiny on the collateral underpinning the loan. These are always secured loans on the collateral quality, underpinning the loans because these loans remain on the books rather than being sold on. So, you know, leading up to the financial crisis, there was a widespread belief that if you widely dispersed the risk amongst financial institutions, you really couldn't be hurt if the loan were bad. And obviously that thesis or theory was proven very, very wrong. Well, because in the private credit space, they're holding these loans on the balance sheet until duration. If these loans go bad, they're going to feel it. And so there is, you know, in my experience, advising these private credit lenders, they're very focused on, you know, the security agreements, guarantees, you know, what are the things that will provide credit support to ensure that if these loans go bad, we will be made whole. And anytime they have strong opinions as to how that language should even be drafted and they're dotting every I and crossing every T to a level that I did not see, you know, to the same extent when I was primarily advising traditional banks on these loans. In this way, because of self preservation, it tends to be, you know, a way for the private credit space to preserve itself and regulate itself, because if they make bad choices, they're going to be out of business and because they're relying. On, uh, you know, capital from sophisticated investors. They're not kind of quote unquote, betting with consumer deposits the way traditional banks do. Um, you know, there hasn't there is a general belief that there doesn't need to be this sort of regulation to protect consumer deposits because they're not being deployed in loans in the private credit space. This variety in collateral quality offers greater fund stability across market cycles in the private credit space. And we've just seen that play out since the global financial crisis. It has been the case and my experience that every time there's a dislocation in the economy, private credit ends up taking up more market share of lending activity, which is why this is the first year that private credit has overtaken traditional bank loans as the largest asset class when it comes to lending to corporates. So let's dig down and get a little deeper with this. Let's discuss the different types of private credit transactions. You've got venture debt. So this is lending to startups or growth companies that do not have positive cash flows or significant assets for collateral. So if you're thinking of kind of early stage companies that are in need of capital, particularly in a, you know, a choppy economic environment where banks typically aren't lending, you've got many venture debt, private credit funds that will lend into those scenarios. You've got direct lending, and these are non-bank lenders lending to a borrower and generally keeping the loan on its books rather than syndicating. You also are we are seeing more traditional lenders, and this has been for some time now. So the Goldmans, the JP morgan's, they now have direct lending units where they're not using consumer deposits to make loans. They are lending in a way very similar to the way a private credit lender would lend just as focused on collateral quality as, you know, a Blackstone or an Aries that is not a traditional bank and has always kind of focused on the credit side with on private credit. And so this is definitely and Barclays recently launched launched this own fund I saw just a couple of months ago. So traditional banks are moving into this space, operating a little bit differently to take advantage of the growth of the private credit market. You also have mezzanine funds, which is an intermediate type of investment between debt and equity more frequently used on real estate finance deals. But we've done many cash flow deals only with mezzanine funds. You usually have a priority system where if a loan goes bad, there's kind of an order of priority as to who gets paid back first. With a mezzanine, with mezzanine debt, they are subordinated to a senior lender, meaning that the senior lender will charge a certain interest rate if the loan goes bad. They get paid first because their debt has a senior priority with the mezzanine lender, they'll get paid second or certainly after the senior lender, they can charge a higher rate of interest to compensate them for the risk that they are not that there aren't enough assets in the bankruptcy for them to fully collect on the loan that they've made. But that has been a very profitable area of lending historically in the environment that you see recently, mezzanine and junior lending activity has has fallen off pretty significantly. But it's like any economic cycle, the activity and kind of mezzanine and junior debt will go up and down with the economic cycles. You've got special situations. And personally, we've recently established a formal distressed debt and special situations. A team here at the firm. You know, these two spaces are special situations and then distressed debt restructuring, finance. Ultimately, what they are first special situations. These are investment opportunities where a lender can profit from a potential rise in valuation due to spin offs, tender offers, M&A activism or complexity that is not generally understood by the market. And then with distressed debt or restructuring finance, this is lending to a company that is at risk for filing, filing bankruptcy or has filed. So this is a form of lending into those situations to either save them from bankruptcy or it's going to be lending as the bankruptcy proceeding is ongoing. So for for both of these areas, they become a very hidden but powerful force within the markets. And so far, as had 2008, a lot of bankruptcies, a lot of carnage really in the market. And then since then, there's been the rise of private credit. You've seen distressed, distressed in the economic system such as Covid. And I think for a lot of folks, there's been a wonder as to why there haven't been more bankruptcy filings. Right. You know, the economy is going terribly. It doesn't make sense. Why are there not more bankruptcy filings? My personal view, based on, you know, where I sit advising in the private credit space is private credit is the reason why you're not seeing more bankruptcy filings. You have a you have a ton of capital, literally trillions of dollars worth of capital now that can be deployed in distressed scenarios that can keep businesses operating without taking that step of bankruptcy, which can be at times destructive and very expensive. And these can keep these businesses kind of operating as going concerns. And so, yes, you will you will always have bankruptcy filings, but we may be entering, in my view, you know, an environment that. Where because of private credit, we're able to keep a lot of businesses going that might otherwise, you know, historically might have gone into bankruptcy. So types of private credit by percent. This is first half of 2019 versus first half of 2021. You know, 2019, you had about half being represented by direct lending. And you see it's gone down to around 40% venture debt, which is at 3.6% for those who are working in the space, will not be surprised to see that that number has shrunk significantly to about 2%. Now, a lot of venture debt activity going on right now. And then you've got special situations, Mezzanine, I guess between those two, it's about 23.3%. When you add those two together, it's around around 32% now. And then you've got distressed, which is a greater proportion too. But that kind of, you know, we are kind of in a distressed environment. A lot of people are saying we're not really in a recession, but there are certain parts of our economy that are certainly in recession, real estate being a notable example. And again, we're able to keep a lot of businesses clear of bankruptcy because there is capital represented here in the private credit space that can keep these businesses going. Next private credit market the player. So who are the players in the market? You've got credit funds, borrowers and investors. So what is a private credit fund? It's an alternative to a traditional bank. As I've said before, these funds rely on capital raised privately from sophisticated investors instead of relying on consumer deposits. And as we've covered earlier in this presentation, this is generally through a buy and hold strategy. So they're going ahead and making loans to these businesses. They're holding these loans on their balance sheet for the duration, you know, which gives rise to a lot of the benefits I described in terms of continuity as to who is going to be the lender during the period of time, better understanding of the business and documentation that reflects kind of the unique circumstances of the business that's being lent to. And then, you know, if these loans go bad. These these lenders are going to feel it. So they're very much in the weeds to make sure they really understand these businesses and that the collateral support, the credit support for these facilities are more than enough to make sure that in a downside scenario where enforcement action, you know which private credit lenders are always trying to avoid, but if the worst comes to worse, they're able to be made whole from the borrowers that they're lending to. As far as strategies for credit funds. Some credit funds look for specific types of credit opportunities. So you'll have kind of a health care private credit fund or ones that are focused on tech or distressed or special situations for as many different strategies and portions of the of the economy that you can think of there at this point is probably a fund out there trying to take advantage by kind of lending into those environments and producing high stable returns from the investors that kind of want exposure to that portion of the economy. Investment can be in a wide variety of situations over the course of the life life cycle of a business and then within various industries and sectors across the economy. And then you can have complex refinancings of companies and secondary transactions. So in an environment like now, um, you know, speaking to someone yesterday and talking about, you know, the idea that, you know, these funds have subscription documents and at a certain point they have to deploy this this capital and, you know, toward toward lending activity. But you're not necessarily seeing a huge uptake of new deals right now. And the response was, well, yes, that's because a lot of that capital right now is being deployed to support companies that are struggling a little bit more. And rather than having to take a mark that is negative towards the valuation of a business that's struggling, they'd rather take a little bit of more money in to help a business that might be struggling through a choppier economic cycle. If the underlying health of the business warrants it and it's clear that the business is good, it's just it just needs to get through a tough time. And obviously borrowers love that. You got as far as private credit lenders, the types of lenders that you can come across, you have credit funds. So this is a generic term for any fund really, that consolidates private capital to deploy in a wide range of investment strategies. Got venture capital funds, which I've described before. These lend to emerging companies and start ups for working capital and capital expense needs. You get BDCs, business development companies. These are often publicly listed and they invest in small and medium sized businesses as well as in distressed companies. We got specialty finance companies. So these are non-bank lenders that make loans to undervalued businesses or to capitalize on complexity not generally understood by the market. And then once again, you have distressed debt funds. So these are funds that focus on lending to troubled but promising companies with the aim of profiting from a recovery. So you may see a scenario where a distressed if a distressed debt fund, they really believe in the business that's truly struggling might go in and might take an equity stake there. And that fund may reap the rewards quite handsomely if they've chosen the right horse and is able to kind of nurse them back to financial health, they get the benefit of the fees and the high rate of interest that they're compensated for. And then because of the equity stake, they also reap the benefit of that business kind of, you know, coming back to life. So who are private credit lenders in the space? You see this graphic here. So as of November 28th, 2021, these 13 asset management companies combined manage more than $16.5 trillion in assets, which is up from around $11 trillion in assets in early 2020. This is according to Seeking Alpha. There will be there will likely be continued positive changes to regulations over the coming quarters, driving up multiples for current investors. Now, this is regulations as a result of lenders like SVB and First Republic going under. You know, there are calls for even higher capital reserve requirements for traditional banks, which will, you know, if some of these regulations come to fruition, once again, you're going to have banks, traditional banks that have a hard time lending and yet again, another opportunity for private credit lenders to move into the space and take yet even more market share from kind of the traditional lending space. So on this page, you've got Blackstone, which I think is the the largest private credit lender that Goldman with their direct lending arm, Aries, Barings, Apollo Global, KKR, a lot of private equity shops also have private credit shops. And it will surprise some people to know that, you know, a lot of shops that are known for private equity at Blackstone being a good example, um, you know, they're in many cases they're private credit arm is actually more profitable than the private equity arm of those same institutions. So this is a huge asset class that has kind of flown under the radar. And again, the market has really woken up to it this year. So who are the key investors in private credit funds? You've got public pensions, private pensions. You've got private funds. You have family offices, some non-profits, sovereign wealth funds, high net worth individuals, insurance companies. So it really runs the gamut at this point in time. I think private credit has proven itself across multiple economic cycles as being a reliable source of stable, high returns. And so whenever you have an asset class like that where you can minimize the level of risk and volatility, but you can get, in many cases, double digit returns over time, you know, it's going to you're going to get a lot of folks piling into that space. And that's what we're currently seeing. As fundraising. Um, you know how that process runs. Usually a firm will launch a private credit fund with a fundraising target. So you'll have a fund and they'll say, We want to raise $1 billion, and then they'll set forth what their strategy is going to be when they deploy that capital in the form of loans. The firm will market the private credit fund by advertising the investment strategy of the fund and the track record of the fund manager, which is very important, particularly in moments like now where, you know, this is a very choppy, volatile environment that they're in. There are many folks who, you know, have never really, truly seen a downturn. Um, you know, since 2008. And this is the first, you know, it's very easy to manage when when things are going well. But how have these funds performed in the down down cycle? Um, you know, this is a this is a period where there'll be differentiation in the market that will kind of separate some winners and losers from the space and probably a way that is healthy for the private credit market generally. And in the fundraising process, a firm may seek a cornerstone investor. That is an investor that contributes a significant amount of capital towards toward toward the target, the fundraising target. And then the fund typically closes after the marketing process is complete. This may result in the fund being oversubscribed or exceeding the capital target or the fundraising target. They that they had at the start and that has happened quite frequently as well. Next, we're going to hit on private credit deals. So the chronology of an actual deal, this is the world that I live in. This is the world that my team lives in at Polsinelli. So how do these deals work? Right? You've completed your fundraising towards a particular strategy. You've hit a particular target. You've got capital to deploy. Your client, if they're a private credit lender, has identified a corporate borrower that they want to go ahead and lend to. So how do you go about negotiating and bringing that deal to a close? Well, at the beginning of the deal, the lender and the borrower will meet to discuss the need for the funding. Why is that capital needed? The purpose or the use of proceeds for the for the loan and how those proceeds of the loan will be used? Is that for an acquisition? Is it for working capital? Is it for equipment? Is it for something else? And then there's just a provision of basic information. So the company will provide the lender a business plan, potential projected income, just general information as to how the business is performed in the years leading up to requesting the loan so that the underwriting process can begin with the lender and they can determine whether this company often called also called a credit, whether this credit is worth investing in in the form of a loan. Um, once the decision has been made by the lender to make a loan, the lender will determine the appropriate type of loan that needs to be made. So it will it be fixed or floating rate of interest these days, especially in the last 18 months to almost two years now where you've had interest rates increasing significantly, you will almost always see floating rate loans. It's very uncommon right now to see a fixed rate loan in this kind of environment for obvious reasons. Priority of the debt, which is what I mentioned before or whenever there's a loan and there's collateral or security involved, there is kind of a ranking system where, you know, if that loan goes bad and and the lender needs to enforce on the collateral, there's an order of priority that that needs to be followed. So lenders will make a calculated decision. They may not their strategy may not rely on them being a senior lender. They may be happy being a mezzanine lender, being very confident in the company that mezzanine or junior lender will be compensated for the increased risk that if there is a default, there may not be enough assets to fully satisfy a senior lender and them. So they're rewarded by that with a higher rate of interest. So that's all sorted out at the beginning there. Unitranche loans where, you know, there may be different priorities of lenders, but to the borrower there's kind of a blended rate of interest. And then the there's kind of a there's an agreement among lenders, which is a form of inter creditor agreement or disagreement that establishes and a default scenario how those lenders will share in the collateral. And then there is a determination as to what portion of the loan each lender will provide. So if it's not a bilateral loan, meaning a loan between one lender and one borrower, but you have kind of a group of lenders kind of sharing the total loan amount in its loan to the borrower. Each lender will determine what percentage of that loan they will take and the deployment of the capital in the form of a loan to the borrower. The lender will request information from the borrower. So there's KYC. So there's information to understand who the borrower is, make sure that you're not taking, you know, taking on a borrower that, you know, operates in a in a country that is a sanctioned company or country, for example. So you can avoid any anti-corruption consequences from doing something like that. If it's a acquisition financing, they'll be purchasing sale documents that the lender will want to take a look at to understand the deal and understand what the the situation that they're lending into. Obviously, historical bank statements, financial statements, and then information about any pre-existing debt. They'll be lean searches that are done to make sure that if this is going to be another secured loan, that there's no issue as to who has priority. Many, if not, I would say most of the time if there's pre-existing debt. In our experience, the new lender will require that existing debt to be paid off as a condition precedent to the loan, to the new loan being closed upon. So the deal. You've got the underwriting process. This can be either automatic or manual and then the process will verify that the borrower and transaction meet all of the firms requirements for credit approval. So every financial institution will have a credit committee or an investment committee. And so the banker that says, hey, I think this is a good idea, I think we should invest in this particular company. We'll have to go to his investment committee. And make that make his or her case as to why that loan should be made to that particular company. In many places, it's kind of a grilling session where people are poking holes in the in the thesis, kind of underpinning why the loan should be made or should not be made. And then if all goes well and, you know, the you know, the investment committee agrees that, yes, this is a good company that we should be lending to. There's a good, you know, high likelihood that we'll be repaid on principal interest and fees. Then the decision will be made by that committee and then the loan will be approved and the borrower will be informed that the loan is approved and you're kind of then off and running. Terms of the negotiation of a deal. Most deals are negotiated in kind of 1 to 3 months. We've certainly negotiated deals in as little as 2 to 3 weeks. Sometimes it's not a pleasant experience when it has to be on a timeline that short. But sometimes duty calls and the timetable is the timetable. And we always do what we need to do to make sure that we're satisfying our clients expectations there. And then the key negotiating points include the financial definition, such as, you know, consolidated EBITDA, which is kind of earnings before interest taxation, depreciation and amortization. Having trouble getting that word out, you'll negotiate kind of add backs to that number, meaning that certain things that are non-recurring that may impact the business that should that a borrower should get credit for in some ways. So make that number as large as possible. And why would you want that number or EBITDA number to be as large as possible? Because there are financial covenants that need to be adhered to many times, tied to, you know, debt to equity or debt to revenue, debt to EBITDA ratios. The larger the EBITDA number, for example, and the debt to revenue kind of a leverage ratio requirement. You know, the larger the EBITDA number, the more debt you're allowed to have outstanding, the lower likelihood that you're going to default on the loan and find yourself in trouble with your lender. You also have to negotiate reporting obligations, you know, financial reporting and other types of reporting. It's really important when you are a legal advisor to understand how your client's business, if you're representing the borrower or the sponsor, how they operate their business from an administrative standpoint. So you need to make sure that they're aware of all of their reporting requirements when things are due and make sure that, you know, the cadence of the reporting. If it's, for example, for a financial reporting, is not more frequent or unduly burdensome as compared to how the business usually conducts itself. And then, of course, events of default, you don't want kind of ticky tack fouls here. You don't want something small to result in a default of the entire event to the fault of the entire loan facility, which would give the lender all sorts of kind of draconian rights on the business and its assets. So those are things that, you know, we end up spending quite a bit of time on when we're negotiating these deals. But as I mentioned before, you know, on the private credit side, this negotiation tends to be overall a benefit to the borrower. These deal terms are more closely catered to the unique characteristics of of the business. So you're going to have the negotiation here. You know, you're not going to you shouldn't get a lot of pushback of, oh, this you know, this isn't market, right, in terms of this doesn't look like every other deal we've done. Yes, there are market terms and provisions and private credit deals, but they're not tied to what will make the loan more liquid in the secondary market. It just tied to other private credit deals in the space with a similar size and sophistication and type of business as the borrower that's currently negotiating a deal is, which is fundamentally different from negotiating, in my experience, fundamentally different from negotiating a broadly syndicated loan deal. Once all the documents are negotiated, you're now preparing for closing. At this point, you're pushing a lot of paper around. All the deal points are kind of discussed and agreed to by the business principals. And now the lawyers really get down to business in terms of making sure that all the conditions, precedent, you know, the things that need to get done before the lender will disburse funds. You're making sure that those things, if it's documentation that needs to be delivered, searches being run, whatever it is, you're making sure that those things are completed. You're finalizing the documents again, conditions, precedents being precedent, being satisfied. You're paying off any existing debt. Like I said before, in many cases, and discharging any existing liens, if any, exist at the time. And if you are successful in all of that, you get to close celebrate. So the documents are signed, become effective, funds are wired to the borrower, if that's what the plan is to have a funding at closing. Sometimes you're just doing a paper close or for whatever reason, the borrower doesn't need the money on the closing date so that the funds can be wired at a later date in that circumstance. But at the end of the day now, all parties are bound by the terms of the agreement and you can close the deal. So congratulations. And then the job is not done. From the lawyer's perspective, you know, you need to make sure that, you know, the collateral, the security that we discussed, the lenders paying a lot of attention to. You need to make sure that their interest in that collateral or security is perfected, which it could. I could do a whole other presentation on perfection of security interests many times that requires filing X might require control in the form of a deposit account control agreement. If it's dealing with revenue and accounts. It really just depends on what the asset is that will determine how it is perfected. And you're making sure that after you've closed the deal, you're taking all the steps. Failure to do that or doing it incorrectly can result in big, big problems. And we've seen that in the past in ways that, you know, we really focus on that very keenly personally. So if you're wondering what the expense allocation is for lenders, you know. You've got kind of conducting the credit analysis about 48% there. You've got borrower negotiations and negotiating the loan documents. That's 7.4%. You've got sourcing viable credit opportunities. That's a big one as well. That takes a lot of time and can be expensive to just identify a lender to help you make the loan. So these are huge expenses. And you'll see here legal advice on structuring products and then borrower negotiation. That's about ten, 11%. So, you know, our fees are not nothing. And, you know, when when you look at them in in isolation, but relative to the overall expense to many of these deals, you know, it doesn't really register nearly as high as kind of the front end work that goes into identifying viable credit opportunities or if you're going to borrow a site or even identifying, you know, a viable lender and then conducting credit analysis on the lender side. So the future of private credit. So we've described how private credit came into being. We've described the private credit market, who the players are. We've moved on to talking about the different types of private, private credit that exist in the market. And most recently, we talked about a typical deal, right? So we've really covered all facets that you as a legal practitioner would need to know about private credit and certainly cover quite a bit that would be relevant to an investor trying to understand the space. So now we're going to talk about the future of private credit. Is there more volatility ahead? Well, this year has certainly been a choppy year. You've had, you know, a huge run up in interest rates. Private credit is, you know, certainly for from the lenders perspective, is pretty protected by that run up in interest rates because they're the loans that they issue are invariably going to be floating rate loans that kind of float, you know, as the interest rates go up and down. So now you talk about. The future and what sort of things people need to be concerned about. When things are going well, that is the time when, you know, the covenants can get a little watered down. So the covenants are the promises really that the borrower needs to make regarding how it's going to conduct its business affairs. Right. And so a lighten the loan, a covenant, lighten the loan is a loan that has fewer restrictions for the borrower. In many cases, these loans allow for borrowers to obtain more financing than they would have access to compared to traditional loans. An example of kind of. A cub like Lone is one that has fewer restrictions on moving assets between group companies. Again, that's an issue that you could spend an entire presentation talking about. When you think about kind of J.Crew and Serta cases, which will not be covered here, but those are circumstances where assets were moved between corporate entities and lenders found themselves not having the benefit of collateral support that they thought they had when they entered into the loan. And that's very incumbent upon the lawyers to make sure that they're getting those things right. Dividends permitted while deferring loan payments or no loan to value, meaning the, you know, the value, the size of the loan versus the overall value of the business or debt service coverage ratio tests. So these are all examples of what would be a hallmark of a light documentation. And again, you're going to find these relaxed standards in environments when the market is really hot. There's a lot of competition among several lenders to make loans to the same borrower or to the same sponsor. And so those borrowers are private equity sponsors get their choice and they can kind of play lenders against one another. And when you're playing these lenders against one another, these lenders and these lenders are competing for the best deal, that's how you get kind of watered down restrictions in the documents in an effort to get the deal. So. Said increased competition can lead to weakening lender protections, particularly when times are good. When times turn and they become choppier, all of a sudden, you know, a lot of lenders will get their discipline back. But we advise, you know, I'm happy to say a lot of the larger lenders, private credit lenders, we advise, are very disciplined through the good times and bad times. And they're not necessarily afraid to walk away from the deal if, you know, there aren't the protections in there to make sure that it's a responsible loan to be making. So when times are good, you can get questionable EBITDA add back. So again, the add backs for something that's non-recurring, I don't know, you're thinking of a future acquisition or synergies from an acquisition that should result in all of this upside and increased revenue and we should get credit for that revenue when we're calculating the financial covenants, when many of them are kind of pie in the sky kind of idea ideas, and you can get some of those through in good times when you can play lenders against each other. And that can lead to weaker loans, weaker, weaker protections in the loans than what you than what would be ideal. Again, we your covenants you can end up two loans less creditworthy borrowers in this environment just because you know these credit funds they have subscription documents with investors. Investors are expecting deployment of their capital on a particular timeline. And so there is some pressure on the lender side to make loans. And if you're struggling in an environment where there's a lot of competition to make loans, you may find that some lenders are making loans to less creditworthy borrowers, borrowers that they may not be they may not otherwise make a loan to just so they can kind of stay on schedule or keep to the calendar that they provided to their investors. So how you handle this? Well, when advising borrowers or private equity sponsors, you want to pay close attention to the key definition. So that's, you know, consolidated EBITDA. The definition is tied to the various types of financial covenants that are in the document because the definitions can can have a huge and critical impact on how the calculations are made to ensure to determine whether a borrower is in compliance with their obligations under the agreement. You want to speak to the borrower, understand the business and make sure the borrower understands the various reps and warranties. Basically the promises and the things that that borrower says about itself and how the business is running that they say in the agreement. So we always go through each one one at a time with our clients to make sure, okay, this document says that this is true about your company. Is that true? Do we need to modify the language? Is this eliciting maybe a schedule where there's kind of exceptions that we want to make clear in the document? Yes, this is true, but except for in these 2 or 3 cases. So we that conversation needs to be very focused and detailed. And then you want to beware of onerous reporting obligations. Like I said before, you know, the these companies operate in a particular way. The clients that you serve, if they're running a company, they're busy running that company. And in many cases, negotiating this loan agreement is a bit of an inconvenience. It's a necessary inconvenience, but it is an inconvenience. You want to make sure that the the administration of this loan does not run. So contrary to how the company runs its business, that it just becomes an obstacle to those business owners are running their business because their time is taken up more than it should be to kind of administer the loan as well. And you want to ensure that the covenants do not create unnecessary obstacles for the borrowers day to day operations. And that's really a benefit for both the borrower. Obviously, it's a benefit to the lender, too, right? You know, the lender wants the company to be able to run in a way where it's as profitable as possible and it can be repaid with respect to principal interest and fees. And so they don't necessarily if it can if they can avoid it, they're not going to necessarily want to create obligations on the borrower that make it difficult for that borrower to help the lender realize the economics that they calculated when they were making their investment decision. When advising lenders what you need to do. Same thing. Pay close attention to key definitions as we did for private equity sponsors or borrowers. We discourage your client from relenting on important covenants, even if that means walking away from the loan. Like I said, many of our clients are good about that without our input. But we know we are not hired just to be scribes and write down what our clients say on a sheet of paper. We view ourselves as kind of, um, you know, conseguiria an adviser, a partner, someone who can add value based on all the other clients that we serve and all the scenarios that we see that our clients may not see all the time. We want to be able to give them good advice as to, Hey, this is a scenario that doesn't look great to us. We were in X, Y, and Z situation and, you know, by taking A, B and C steps, you can protect yourself. Or if you don't do that, you know, these are the particular consequences that you'll see. That's very much the way we practice. And then personally and then we want to ensure that the lender receives the credit support that they expect to receive. So we need to avoid any trap doors in the documentation. You want to make sure that all the security interests are properly perfected in the deal, which is the next point. You want to make sure that all the security interests are properly perfected in the deal. And that's about it for today. Thank you for the time that you have taken to sit with me and learn from me. It looks like we are at time as well. It's been a pleasure discussing, you know, my intellectual passion these days, which is private credit. It's been fun. Being on this ride is the asset class has grown to the extent that it has. And do you have any other questions or you want to learn more about what we've discussed today? Feel free to reach out to me again. My name is Gabriel Yomi Dabiri and I am the leader of Polsinelli's private credit and cross-border Investment Business. Thank you.

Presenter(s)

GYD
Gabriel Yomi Dabiri
Partner
Polsinelli LLP

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