Two dangers to watch with private equity trusts

These lurking dangers mean good times for investors in private equity trusts may come to an abrupt end.

Is the private equity industry about to trigger the next global financial crisis? For regulators whose job it is to keep a constant watch for looming risks to the financial system, the record levels of leveraged loans taken out by private equity-backed businesses are now causing real alarm.

Central banks have issued a series of alerts about this corner of the debt market in recent months, with the International Monetary Fund and the Bank for International Settlements the latest to join the chorus. Elizabeth Warren, the US senator known for her work in financial protection, wants tougher regulation of an area she says is now "a significant risk to the financial system and the American economy".

For the uninitiated, leveraged loans are those made to companies that already have significant debts. Private equity funds are particularly fond of this form of credit, using leveraged loans to refinance the debt of the businesses they buy, or to underpin the M&A activity they pursue through the companies in their portfolio. Not all leveraged loans go to private equity-owned businesses, but the sector has been a major driver of growth in this form of credit.

And what growth there has been. The IMF says the value of leveraged loans outstanding has more than doubled over the past decade and now stands at an eye-watering $1.3 trillion (£1 trillion). New loans totalled more than $600 billion last year alone, with issuance now at highs not seen since 2007 – an ominous precedent.

This has been a global phenomenon. The US dominates the leveraged loan market, but Europe is catching up, with the UK, in particular, recording a sizeable jump in lending. The Bank of England says new leveraged loans hit an all-time high of £38 billion in 2017, with an additional £30 billion lent during the first three quarters of 2018.

Lenders love leveraged loans because they are easy to package up and sell on in the form of collateralised debt obligations (CLOs). Since leveraged loans carry a variable rate of interest – and interest rates are widely expected to rise in the years to come – investors are keen to snap them up.

For borrowers, meanwhile, the debt represents an easy form of credit. All the more so because lenders keen to get more loans out of the door seem inclined to hold their noses when it comes to issues of creditworthiness.

Traditionally, loans to businesses carry strict covenants, requiring borrowers to maintain certain standards – a minimum ratio of earnings to interest payments, for example, or a cap on debt as a proportion of equity value.

With leveraged loans, by contrast, these protections are often much weaker or even non-existent. According to the credit rating agency Moody's, the covenants on leveraged loans today are, on average, less than half as strong as they were a decade ago.

"With interest rates extremely low for years and with ample money flowing though the financial system, yield-hungry investors are tolerating ever-higher levels of risk and betting on financial instruments that, in less speculative times, they might sensibly shun," warns Tobias Adrian, one of the IMF directors who authored its research into leveraged loans.

"For their part, speculative-grade companies have been eager to load up on cheap debt…underwriting standards and credit quality have deteriorated."

The fear is that the combination of growth in leveraged loan issuance and the fact so much of it is "covenant-lite" could prove to be toxic. As interest rates rise, more borrowers will struggle to keep up with the repayments on their loans. Any significant economic deterioration – widely predicted sooner rather than later – that hits company earnings could be equally disastrous. In which case, boom, yet again, will be followed by bust.

How the private equity trusts recommended by analysts compare

Notes: *Recommended by Stifel; ^by Numis Securities; + by Canaccord Genuity. Data source: Association of Investment Companies

Two dangers to watch

For private equity funds – including the listed private equity investment trusts – there are two dangers. First, there is the risk of significant losses on portfolio businesses that cannot cope with the weight of the debt on their balance sheets in a rising interest rate environment or a period of declining trade.

The second potential problem is contagion: that the broader debt market goes into reverse in the face of a significant leveraged loans blow-up. That would damage private equity funds’ ability to manage their portfolio holdings – and hit the valuations of businesses they are planning to sell on.

The doomsday scenario – a systemic crisis caused by the bursting of the leveraged loan bubble with debtholders paralysed by defaults – is what regulators fear most.

Credit market analysts point out, however, that lenders are better capitalised than in the last crisis and thus better able to cope with significant default rates on leveraged loans. Most loans, moreover, are syndicated – made by several lenders – spreading the impact of a default.

Still, in a market of this size, the possibility of a spectacular crash cannot be discounted.

Where does that leave the private equity sector – and particularly the 20 or so investment trusts that offer retail investors access to an industry more usually reserved for their institutional and high-net-worth counterparts?

Well, leaving aside the possibility of a systemic collapse – potentially ruinous for all asset classes – setbacks in the credit sector are always bad news for private equity funds, warns Charles Cade, director of research at Numis Securities.

"The health of the debt market is obviously important to private equity investors as the availability and pricing of debt is a key element in deal pricing," he says.

"Many private equity investors have taken advantage of favourable debt markets to refinance investments and return cash."

More positively, Alan Brierley, director of the investment companies team at Canaccord Genuity, believes private equity trusts have learned the lessons of the past, structuring their portfolios with greater caution than in previous cycles.

"While listed private equity would not be immune in the event of sustained weakness, we believe that having learned such a painful lesson during the last crisis, there is now a much greater capital discipline, with strong balance sheets and high-quality portfolios representing defensive qualities," Brierley argues.

That caution hasn't stood in the way of performance. Canaccord Genuity analysis, based on nine-year performance that excludes the exceptional year of 2009, when private equity funds plummeted in the wake of the financial crisis, depicts an impressive run. Listed private equity trusts have returned an average annual gain of 11% since then, against 7% from the FTSE All-Share index.

Signs of nervousness

Still, there are some signs of nervousness. Not least, shares in most trusts in the sector trade at double-digit discounts to the value of their underlying assets – the sector averages around 16% as a whole according to Morningstar – at a time when investment trust discounts are more typically close to historic lows.

That may suggest anxiety about the exposures in private equity portfolios.

Nevertheless, many investment trust analysts remain optimistic about the sector’s prospects. "We see further upside for listed private equity net asset values," says Cade at Numis.

While it's possible to make a case for private equity trusts, investors would be mindful to consider the broader industry's role in the build-up of risk in the leveraged loan sector.

The listed trusts to which retail investors in the UK have access may not have played a significant part in that build-up, but they will nonetheless be caught up in the fall-out of a correction or collapse.

Be cautious with credit funds

Investors who are nervous about the links between private equity trusts and leveraged loans should be even more cautious about those closed-ended funds investing directly in the credit markets. More than 30 investment trusts are now active in the debt sector, raising money from investors desperate for yield, and some have direct exposure to covenant-lite loans.

Listed debt funds that specialise in loans included NB Global Floating Rate Income (LSE:NBLS), Alcentra Eur Floating Rate Income (LSE:AEFS) and CVC Credit Partners European Opportunities (LSE:CCPG), advises Numis Securities' Charles Cade.

"There are a number of potential red flags in the senior loan market, including aggressive new issuance terms such as the increase in covenant-lite and single-B [credit-rated] issuance," he warns, echoing the concerns of regulators.

At Canaccord Genuity, meanwhile, Alan Brierley points to recent guidance from Neuberger Berman, manager of NB Global Floating Rate Income, which warned of increased defaults and lower recovery rates during any economic slowdown.

"A rising [interest] rate environment should be supportive for short-term relative performance, but overriding this short-term outlook, we are mindful of growing concerns about the leveraged loan market when this credit cycle ends," Brierley warns.

That's not to suggest that moment is imminent. But when the party does come to an end, expect some revellers to have a nasty hangover.

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