While policymakers and regulators sound the alarm over hidden risks in the fast-growing market for private credit, alternative asset managers running such funds typically explain that they see lower-than-expected default rates and – more importantly – lower loss-given default for three, inter-connected reasons.
First, they claim seniority in the capital structure with first-lien loans secured against operating company assets.
Second, strong covenants in direct-loan documents require corrective action if, for example, a borrower looks likely to see its earnings fall below one times required debt service.
And third, even if it can’t prevent that, private equity sponsors often stand ready to inject fresh capital in order to retain full ownership of any borrower going through a cash squeeze that might lead to a covenant breach but that still has strong prospects once it gets though a temporary downturn.
That is the theory.
But in the real world, stressed borrowers desperate to raise new financing might be willing to attract new lenders with a preferential position in the creditor hierarchy that structurally subordinates existing lenders who thought they ranked first in line for whatever might be recovered in the event of bankruptcy.
