BETWEEN about 2018 and 2021, I heard from a lot of debt investors who were unhappy about what they were being asked to swallow in the booming market for financing private equity deals. Ambitious lawyers — even more than sharp-toothed dealmakers — were driving the degradation of lending standards, providing less protection if a borrower went south.
Many managers felt powerless to fight it: They needed to put money to work because sitting on cash pays nothing.
As ultra-cheap money drove a manic hunt for yield, debt investors competing for a piece of new deals accepted ever-weaker safeguards in loan contracts. These are the covenants and secure claims to collateral that help lenders recover their money when overleveraged businesses get into trouble. Now is the time to start regretting this behavior. Sharply higher interest rates and slowing economies are putting pressure on the cash flows of many of companies. Debt refinancing problems and complicated workouts are likely around the corner.
There’s a dynamic here familiar from every financial bubble: When money is plentiful and competition for assets is high, investors end up cutting corners. One way they do this is by assuming someone is acting in their interest when in fact that link in the supply chain for the hot investment might be doing no such thing.
In the market for lending to private equity-owned companies, it’s the role of lawyers that has emerged as a novel problem this time around, according to an in-depth report from Bloomberg News. As firms such as Chicago-based Kirkland & Ellis came to dominate the field, they drove more aggressive contractual terms for their private equity clients and even gained the power to appoint the lawyers that would represent lenders opposite themselves in financing negotiations.
Markets regulators in the UK and other countries are looking into practices in the leveraged-debt markets, including some of the tactics used by lawyers, according to the Bloomberg report. Some of those tactics made the process of negotiating and selling loans faster and more efficient for all involved, but at a cost of a loss of power over due diligence for investors.
The erosion of lending standards in the recent boom didn’t just involve watering down traditional covenants, although so-called covenant-light deals became even more prevalent than they were in the run up to the 2007-2008 credit crisis. There were also new crimes against prudence, such as basing financial-strength assessments on rosier, pro-forma versions of company earnings, or designing contractual backdoors through which valuable business assets could be taken away from the claims of lenders. (The latter made clothing brand J. Crew into a nickname for the practice.)
Maybe investment managers had little choice, or maybe it’s an abdication of responsibility. A mutual fund that ends up holding too much cash will underperform fully invested peers in the short-term at least. A collateralized loan obligation (CLO) that holds too much cash will struggle to pay the interest on the debt that funds these structured investment vehicles. Either way, it’s a classic agency problem: A conflict between, on the one hand, the ultimate investors in the funds or vehicles that buy the loans and, on the other, the managers of those funds and CLOs. When a manager is forced to buy whatever assets they can get, they can’t be acting fully in the interests of investors, which at the end of the line is you and me through our pensions, mutual funds, or insurers.
It took some time for investors to realize quite how much power had accrued to lawyers in the leveraged-loan markets, but concentrations of influence are common in hot markets. In the US subprime mortgage bond and structured finance boom before the 2008 crash, investors frequently took the approval stamp of credit-rating companies as a sign that a deal was sound. That shortcut ended in disaster — to say the least. In the dotcom boom of the late 1990s, or the crypto boom of recent years, seeing another recognized investor backing the latest thing was enough for many others to jump in without looking much deeper.
There are situations where such trust pays. When Warren Buffett backed struggling banks and insurers during the global financial crisis for example, his imprimatur was a reliable signal. Similarly, the Lloyd’s of London insurance market has operated for decades on the basis that an expert lead underwriter assesses a complicated risk and others (who are expert in different risks) subscribe funds based on the leader’s view. Neither example is a guarantee against loss, but they at least make sense.
Investors have to be extremely careful where they place their trust and who they allow to accumulate power over their choices in any market, but especially during booms. Now that leveraged finance is stuttering, some loan investors are starting to hire second, shadow lawyers to look after their interests.
The real lesson of all of this is that investors should do their own work as much as possible, or at least ensure they are following someone who will definitely do it properly.
BLOOMBERG OPINION
