Direct lending has a transparency problem
Permira Debt Managers was once proud of its investment in Paperchase, a UK stationery retailer. Nowadays, he seems less inclined to cry out.
The credit investment division of the European private equity firm, commonly known as PDM, provided a £ 32million loan to the chain store in 2015 from one of its ‘direct loan’ funds . PDM then produced an online case study praising the company’s “market leader presence in a stable market”.
But earlier this year, Paperchase underwent a debt restructuring after experiencing financial difficulties. The case study is no longer online. The accompanying video either.
And until recently, the press release announcing the 2015 loan to Paperchase was also missing from PDM’s website archives. The ad was reinstated on Tuesday after the company received questions from the Financial Times.
The disappearance – then reappearance – of documentation is a sign of one of the biggest problems in the booming direct lending market: a lack of transparency.
Direct loan is one of those wonderfully imprecise financial buzzwords. The common theme among the various activities he describes is that funds provide businesses with loans that were traditionally made or arranged by banks.
It could conjure up images of a family business getting a lifeline after its local bank, moaning under the weight of tighter post-crisis regulations, withdrew from lending. It may be, but in reality these debt deals often support the same type of private equity buybacks seen in the junk bond market, but on a smaller scale.
When credit funds invested primarily in bonds and loans arranged by banks, it was easy enough to see signs of exuberance. The terms of a high yield bond deal are public, and when a company with this type of debt starts to go wrong, the plunging value of its bonds is displayed on a screen for all to see.
Even in the more opaque market for leveraged loans, the secured loan bonds (CLOs) that dominate this type of loan must regularly report their holdings and valuations. The fact that this debt is so widespread also means that serious problems quickly become public.
But with direct lending, loans are negotiated privately, either bilaterally or between a handful of fund managers. This means that it’s harder for outsiders to see when conditions get frothy and there’s a lot less scrutiny when investments turn sour.
This is of particular concern as direct lending funds are mushrooming in a world of low returns on conventional fixed income investments. Direct loans now represent nearly a third of the 56 billion euros held in Luxembourg private debt funds, for example, against less than a fifth last year.
In the rush to deploy all that capital, the funds might apply more flexible due diligence standards.
Take a loan of 200 million euros that the European credit fund Alcentra granted a year ago to the Irish group Clanwilliam, a health technology company owned by American insurance contractor Greg Lindberg.
In September 2018, two months before Alcentra signed its loan, a U.S. federal grand jury subpoenaed Mr. Lindberg to appear in a criminal investigation. The prominent North Carolina businessman was then indicted in April on federal criminal charges of conspiring to bribe the state’s insurance commissioner for more favorable regulatory treatment.
Mr Lindberg strongly disputes the charges and is pushing for the case to be closed. Alcentra, which is owned by US bank BNY Mellon, declined to comment.
We cannot say whether the fund discovered the subpoena in its due diligence process. But if the banks had marketed a public high-yield bond deal for the company, they likely would have been required to disclose these legal proceedings in the deal’s prospectus.
Turning again to PDM, a recently little-known rating agency filed a report saying he was considering a loan that the manager had made in default. The loan represented 17 percent of the assets of the company’s second direct loan fund. The borrower has not been made public, but according to a person close to the fund, the debt is from Getronics, a Dutch IT services company which announced a restructuring last month.
The July 2018 press release announcing the $ 550 million loan, which PDM granted alongside Canadian pension fund CPPIB and U.S. private debt specialist White Oak Capital, is still on the company’s website. By having essentially functional archives of all its transactions, PDM is more open to its investments than many of its European peers. Still, lenders shouldn’t have to restructure debt a year and a half after providing it.
The wave of money pouring into direct lending funds means that they can often supplant high yield bonds and leveraged loans. This means that there are fewer clear indicators of the start of a credit cycle. As a result, the overall market is worse off.