Private credit: a new force in restructuring

The speed and timing of the growth of the private credit industry means that we are yet to see that shift in the lending market fully reflected in insolvencies and restructures. In the near term, we expect that private credit will begin to play an outsized role in Australian restructurings and, longer term, will fundamentally change how solvency crises are approached.

Lenders are not all created equal

An understanding of the structural differences between a private credit fund and a traditional lender is fundamental to an understanding of why they operate differently in a solvency crisis.

Funds can adopt myriad different structures and obtain their funds from a range of different sources: while pension and superannuation funds are big investors in credit funds, high-net-worth individuals and family offices also have exposures. Some funds are publicly listed – and recent media suggests more will list in future. Given the recent volatility in other investment markets and the growth of pension and superannuation funds, it is hard to see an end to the growth of private credit in the near term.

What is common to all funds is that the investment manager will be restricted in its investment choices by the mandate of the fund, the returns it needs to generate, and the term of the fund or its investment horizon. While restricting funds, these same factors also put pressure on funds to deploy capital, especially where the investment manager intends to raise capital for another fund and needs a track record of returns.

The key pressure points on traditional lenders are quite different. The bond and securitisation markets regularly accessed by the banks operate in a very different way where, among other things, investors are looking for exposure to a more diversified loan portfolio or an exposure to whole-of-bank liquidity. Banks are exposed to an enormous amount of public scrutiny, especially after the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. They are also subject to a heavy regulatory burden, which limits how distressed loans are treated and the restructuring options realistically available.

Different pressures create different restructuring outcomes

Many private credit funds think and operate in a way that is more similar to a private equity fund than a traditional lender. In our experience, private capital can be uniquely incentivised to maximise returns on each individual loan in a fund and have greater flexibility to do that in a distressed scenario.

The growth of private credit funds and the pressure on those funds to deploy capital has produced a greater range of options for companies in distress. We are seeing an increasing number of traditional lenders working directly with private credit funds on partial or complete refinancings of their exposures, which produce a greater return to those lenders than an exit via the secondary debt market. It is difficult to see an immediate catalyst for a credit crunch in the Australian market and we instead expect to see an increase in stressed and distressed refinancing.

Cyrus Church from Neu Capital explains:

The funds we are talking to are seeing much higher inflows than this time last year – there is a desire to get fixed returns in a time of real volatility. We have been looking out for distress in the market for a while now and have not seen it in a systemic way like we have in previous downturns, though there are increasing issues in the sub-prime lending space. Right now is a wonderful time for borrowers to push the envelope – whether it's a management buyout, recapitalisation or restructure."

We expect that the structures used to implement those distressed financings and restructures will become more creative and value accretive as private credit funds increase their share of the market. For example, debt to equity swaps have long been in the Australian restructuring toolkit, but we are seeing an increasing number of these occur consensually and out-of-court, especially where the lender group no longer includes any traditional lenders. Where private credit funds are not able to hold equity or hybrid instruments, they are often able to involve a related fund to do that. Where that is not possible, many private credit funds are able to negotiate structures that solve a short-term liquidity issue while still providing returns commensurate with the risk, which traditional lenders may find difficult to credit approve or fit within regulatory frameworks.

Australian borrowers are also increasingly aware of the diversity among private credit funds, and how those differences can drive behaviours or produce risks. Mr Church explains:

There is a wide variety of quality in credit funds in terms of expertise as well as execution. There was a time when some funds had multiple term sheets issued but not enough funding to meet the commitments in those term sheets. It is hard for borrowers to have an idea of certainty of funds without knowledge of the investors, leverage, funds under management or the fund's track record."

We are seeing borrowers, especially those with debt advisors engaged, avoid lenders with a history of behaviour that could be characterised as difficult – whether that is a lack of certainty of funds or terms that are not considered sufficiently flexible. We are seeing some borrowers refinance away from lenders that they perceive to be difficult even where the refinanced pricing is higher. These trends only increase the pressure on parties to approach a solvency issue creatively.

Liability management transactions – as scary as they sound?

Many private credit providers are offshore funds that are well familiar with liability management transactions – and much has been written recently about the potential for those transactions to be brought into the Australian market.

Although we expect increasing creativity in restructurings, we are sceptical that we will see a significant number of US-style liability management transactions in Australia. The Australian market is considerably smaller and tighter than the US or European markets – the reputational fallout for dealmakers will play differently here than in those markets and the potential returns will usually be much smaller. For those investors that are not already exposed to the Australian market, legal advice and establishing regulatory compliance procedures will further eat into those returns. These issues are exacerbated by the likelihood that further disruption in US markets will create a higher than usual number of opportunities for funds.

To some extent, the flexibility now available in the market as a result of the influx of private credit may reduce the incentive for parties to consider aggressive liability management strategies, especially where a refinancing is possible. We are continuing to see sponsors work constructively with lender groups as a whole and, where appropriate, handing back the keys in order to avoid a formal insolvency and preserve relationships for the next deal.

Key takeaways

Private credit has become a powerful force in Australian debt markets, but the speed of its growth means that we have not yet seen its full impact on restructuring and insolvency.

Private credit lenders are uniquely incentivised to maximise returns on specific exposures have a far greater degree of flexibility than traditional lenders. We are seeing an increase in competition in the private lending space which will further highlight those differences.

While we do not expect aggressive liability management transactions to become widespread in the Australian market, we do expect a far greater degree of creativity in the way that parties approach distressed situations. We expect well-advised borrowers will be able to work with lenders to create innovative solutions that may not have been possible even a few years ago. Private credit will increasingly be a solution to distressed exposures for traditional lenders, either via a refinance or a trade on the secondary debt market.

_Disclaimer

_{Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.}