For an accessories retailer called Charming Charlie, the path to bankruptcy arguably began with a strategic blunder: just as Amazon was undermining brick-and-mortar retail, the Houston-based chain opened nearly 100 stores, each one a rainbow of cheap trinkets and handbags.
At Six Month Smiles, a maker of invisible dental braces for adults with wonky teeth, a drive to make the business more digital floundered and missed financial targets led to problems with its debt.
And Southern Technical Institute, a for-profit school in Florida whose subordinated debt is now reckoned almost worthless, simply could not catch a break. First came the Obama administration’s regulatory crackdown on corporate-owned colleges. Then, last summer, a rough hurricane season compounded the financial hit.
These delinquent borrowers ran into trouble despite an unbroken streak of economic expansion that is among the longest in US history. Their struggles, documented in public filings by some of their creditors, have become an early test for the “shadow” finance providers that are replacing traditional banks as the chief creditors to a swath of corporate America.
Leveraged loans, commercial lending to US companies with credit ratings in junk territory, reached $564bn last year, topping the high water mark reached on the eve of the financial crisis, according to the International Monetary Fund.
Much of the money comes from pools of capital run by private equity firms and other asset managers. Cheerleaders say that these funds, unlike banks, can safely take risks without endangering the financial system or inflicting unnecessary pain on wayward borrowers.
Still, even some of those responsible for crafting the deals worry that an insidious build-up of risk, abetted by policymakers and all but invisible while the economy is still growing, could again erupt in a downturn.
Private credit funds now command a record $162bn in unused capital, and can boost their firepower further by using cheap bank debt to finance higher-yielding business loans.
Lenders say they have curbed risky activity, rarely offering more than six times a company’s stated earnings before interest, tax, depreciation and amortisation. (Crisis-era regulators imposed the same limit on US banks, although the Trump administration has in effect repudiated the cap.)
Nonetheless, direct lenders often justify bigger loans by tinkering with the way earnings are defined. Last year, about one-quarter of leveraged buyouts were financed on the basis of “adjusted” ebitda numbers, calculated by adding back some costs that are customarily deducted from profits, according to the International Monetary Fund.
This ready source of credit has helped propel asset prices higher, providing a fillip to midsize businesses and the private equity funds that often own them. For now, the lenders, too, are enjoying solid returns. In 2015, the most recent year for which meaningful data are available, even a bottom-quartile credit fund posted annual returns of 7.8 per cent after fees, the Preqin data show.
But measures of loan quality are deteriorating, as an influx of capital forces lenders to compromise on pricing and trade away protections they once deemed non-negotiable.
The IMF reckons that strong covenants were attached to fewer than 30 per cent of the leveraged loans issued in the US last year. That compares with 70 per cent during the covenant-lite lending frenzy that many viewed as an aberration in 2007. Now it looks more like a watershed. Some borrowers are even winning the right to force lenders to choose company-approved lawyers as counsel, according to a person who has seen loan documentation issued by many leading funds.
“The documents are important,” said a senior executive at one of the biggest direct lenders. “But having solid credit with strong business fundamentals is really what’s going to get you paid back. Picking the right credits is what’s going to save you in a downturn.”
Meanwhile, another category of lender is itself being allowed to lever up, taking on more of its own borrowing in order to increase its lending activity and juice returns — potentially increasing risk.
Congress last month loosened the rules governing so-called business development companies (BDCs), which enjoy favourable tax treatment to help channel credit to small and midsize businesses.
These funds now count upwards of $30bn of assets, not including some harder-to-measure vehicles that are not listed on the stock market. Many BDCs are run by leading private equity firms such as Apollo and Bain Capital, adding to the firepower of the private credit funds these firms also control.
The new rules allow BDCs to borrow $2 for every $1 they raise from investors, double the previous limit — prompting one rating agency to put the entire sector on credit watch.
“This is coming at a really poor time in the cycle from a risk perspective,” said Matthew Albrecht, a managing director at S&P Global Ratings. “Most middle-market loans now have loose or no covenants. Pricing has gotten very competitive. It’s a reflection of all that capital out there, chasing all of these deals.”
Defaults on business loans are hovering about 2 per cent, less than one-quarter of the rate in 2009, and well below the level Mr Albrecht expects to see if the US economy stalls.
Public market investors are expressing their concern: listed BDCs, which were trading at a modest premium to their book value for much of last year, have fallen to a 12 per cent discount. Ryan Lynch, an analyst at Keefe, Bruyette & Woods, says this may reflect fear of future writedowns; alternatively, the flood of money chasing lending opportunities may have made interest rates unattractively low.
Funds run by leading managers such as Apollo and Ares are among those trading at a small discount. Those with the widest discounts tend to be smaller players that have suffered credit losses.
THL Credit, one of the BDCs hit by Charming Charlie’s failure, saw its income fall nearly 7 per cent last year, as it exchanged interest-paying loans for an equity stake in the reorganised company.
Performance fees have been waived this year in an effort to boost the fund’s stock market valuation, but some investors doubt whether that is a sustainable solution. “The market’s going to look through all this bull****,” complained hedge fund manager Leon Cooperman, an investor in THL Credit. On a recent earnings call, he argued that better quality lending — or a sale to a bigger player — would do more for the share price.
Sceptics of the direct lending model say private credit funds lack the infrastructure of the big banks they have replaced, and will struggle to handle large numbers of defaults, which they believe are inevitable when the economic cycle turns.
Mr Lynch, the KBW analyst, reckons the biggest funds, controlled by sophisticated asset managers, are better equipped. “If a loan would ever go wrong [at Blackstone or KKR]”, he says, “they would bring in their workout team to help out.”
Others argue that loose contractual terms will force lenders to wait for longer before declaring a default and deploying their restructuring teams, raising the prospect that value will already have been squandered.
“The BDCs are doing stuff that banks don’t want to do — smaller lenders, more risky lenders, more leveraged lenders,” says S&P’s Mr Albrecht. “This is an inopportune time to double your leverage tolerance.”