March 2020

Only a few weeks ago (although it now feels like another era), Fund Finance Partners (“FFP”) published an article on the numerous ways that direct lending funds and BDCs (collectively, “Debt Funds”) could finance their investment portfolios in order to increase liquidity, enhance returns and offer more competitive spreads to borrowers.  (Article)  Now, though, is the time for Debt Funds to confront challenges in their portfolios, and fund-level leverage defaults, aggressively.

Since the outbreak of COVID-19, followed by the ensuing dramatic social and economic isolation meant to contain it, the entire economy is showing its first signs of widespread contraction in over a decade.  Practically all asset classes and sectors are impacted, but for purposes of this alert, we are focused on how this economic slowdown, which severely impacts corporate earnings and liquidity, is impacting the ability of Debt Funds that have, over the course of the past decade, increasingly met their financing needs, to continue to do so.

Debt Funds, in the aggregate, have billions of dollars of unfunded commitments to portfolio companies, whether in the form of revolvers or delayed draw term loans.  Likewise, Debt Funds will be called upon by portfolio companies to provide incremental rescue financing as practically the entire economy struggles to hold onto precious liquidity.  Prior to the onset of this crisis, Debt Funds had been availing themselves of more, cheaper and even structured leverage for a while.  Most of these credit arrangements were made with financial and other covenants that the Debt Fund must maintain in order to access debt capital.  The fact of the matter is that the banking system, which largely left the small and medium-sized business leveraged lending market to the Debt Funds, after the downturn, is once again a critical source of liquidity to small and medium sized businesses, as well as middle market companies.

For most Debt Funds’ credit facilities, one of the covenants that must be maintained in order to be able to access precious debt capital is some type of “NAV” or “asset coverage” covenant.  The valuation component of this covenant moves up or down, based on the value of the underlying portfolio of loans.  Many of these loans are valued by applying an enterprise value, based on an EBITDA multiple, to the company’s capital structure waterfall.  As earnings decline across the board, those enterprise values are expected to fall precipitously, and loans marked at par today, or on December 31, 2019, may not be on their next valuation determination date.

Deterioration of asset values is expected to lead to NAV or asset coverage covenant violations, for many Debt Funds, resulting in credit facilities being unavailable (or worse, called), only further starving small and medium sized businesses and middle market companies’ liquidity.  Meanwhile, Debt Funds that are out of covenant compliance due to NAV deterioration are expected to be negotiating amendments or forbearances with their lenders, or seeking liquidity from other sources.  Margin calls and mandatory repayments are undoubtedly coming, and some Debt Fund managers are – painfully – considering selling valuable, performing assets in a market where all asset prices are falling.

FFP has been in discussions with several Debt Fund managers over the past week, developing finance-based or stop-gap liquidity solutions to either temporarily or indefinitely refinance credit facilities that are in danger of being pulled from Debt Funds, or to arrange for partial refinancings, in which performing loans are left in place, securing the existing credit facility, and fallen angels are used to collateralize new, rescue or curative financing.  All refinancing possibilities should be considered and discussed with your advisers, prior to distressed sales of good assets.

Whether your Debt Fund’s assets are quotable on a daily basis, and a covenant breach is imminent, or your Debt Fund’s loans are not quoted, but subject to quarterly revaluation on March 31, or June 30, now is the time to educate yourself regarding all options.  Debt Funds that act now, before the inevitable margin calls (in TRS-financed portfolios or CLO warehouses), mandatory paydowns (resulting from loan quality deterioration) will receive better terms than those that “wait and see” or hope for a V-shaped recovery.   FFP is available now, to help implement solutions.