Alternative Investment

Private credit investors turn to asset-backed loans

Andre A. Hakkak, co-portfolio manager of credit manager White Oak Global Advisors LLC with $8 billion in AUM, said the firm is “very keen” to increase its investment in asset-backed loans because of their inflation-hedging qualities.

Some of the assets backing the loans are an integral part of the companies’ operations and the loans are generally offered at a discount to the value of the asset and so the lender will make a profit if it has to foreclose on the asset and sell it, Mr. Hakkak said.

These assets can include the trucks a company uses to deliver its goods or the servers for robotics, he said.

What’s more, not all direct lending to companies have the same risk profile, he said.

Loans to private equity-backed companies make up only about 5% of the direct-lending universe, Mr. Hakkak said. Many of the private equity-backed companies that private credit managers had lent to were highly levered, he said. So, these companies will be in a situation where cash flow is tight due to the economy, while at the same time their interest payments on their loans will continue to rise as interest rates increase, Mr. Hakkak said.

“There will be many, many cases in the coming quarters” in which some of these highly levered companies will not be able to pay interest, he said.

Richard Miller, Boston-based chief investment officer and group managing director of private credit at TCW Group, agrees that lenders to private equity-backed companies may have to start marking down their portfolios in the current market environment.

Loan contracts with very few covenants to protect the lender, called covenant lite, infiltrated the middle market, Mr. Millier said.

“I think lenders with covenant-lite contracts ceded a very important tool” in their loan arsenal that protects the investors principal and gives the lender a seat the table to help the company work out its problems, he said. Without covenants, the lender cannot affect the company’s operations but “watch from outside the room” while the company loses value and runs out of money, Mr. Miller said.

Most of TCW’s loans are not for private equity-backed loans and it doesn’t enter into covenant-lite lending agreements, he said.

Asset-backed loans have always been around, Mr. Miller said. They tend to gain in popularity when the economy slows down because “people want to be in hard asset lending,” he said.

Some of TCW’s loans have some component of hard asset loans.

Its portfolio is a mix between service-oriented firms, asset-lite companies such as software and companies with more collateral, such as industrial companies.

“I don’t know if the lending approach is materially different,” Mr. Miller said. Lenders are looking at the resiliency of the value of that collateral, he said.

If there is real estate, for example, it can be repurposed and sold, mitigating the lender’s risk, Mr. Miller said.

“As a lender, we’re not paid to be optimistic. If we’re right, we get our money back,” Mr. Miller said. Unlike in private equity, “your wins don’t offset your losses,” he said.

“There seems to have been a big increase in optimism in our (private credit) market” with the proliferation of loans with fewer covenants and higher debt to earnings before interest, taxes, depreciation and amortization, Mr. Miller said.

“I’d be concerned if I were following a more optimistic path,” he said.

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