Caisse Warns of Giant Risk in Private Debt

Paula Sambo of Bloomberg News reports that the Caisse sees giant risk growing in corner of the private-debt market:
Direct lenders and big banks are competing for the largest companies in the red-hot market for private credit, which is eroding underwriting standards, according to Canada’s second-biggest pension fund manager.

“The bigger, more solid companies are closer to having access to capital markets, so there’s a bit more erosion there because you have large direct lenders that are competing with each other,” along with the big banks to offer credit, said James McMullan, head of corporate credit for Caisse de Depot et Placement du Quebec, which has about $327 billion under management.

Like other asset managers, the pension fund is working to increase its exposure to higher-yielding private credit, but is doing so slowly as finding and screening companies is labour intensive, said McMullan. The Caisse currently holds around US$4 billion in the market, part of its US$41 billion credit portfolio.

“We definitely think there’s an opportunity in private,” said McMullan. He divides the private-credit middle market into three blocks: companies with less than US$30 million in earnings before interest, taxes, depreciation and amortization; those with between US$30 million and US$75 million; and those with US$80 million and up. It’s the upper end that’s seen the most erosion in credit quality, he said.

“I don’t know what too much is, but there’s a heck of a lot of capital, which leads to some perversions because everybody is looking for the right opportunity,” McMullan said. “So things are becoming more expensive, structures are getting eroded.”

Points of concerns when looking at covenants are often associated with definitions, McMullan said. He pays attention to subtle details such as how many pages are used to define the terms in the credit agreement, especially the Ebitda.

Workout Situations

“Some are a nice 10-line-paragraph, short and sweet, pretty simple to understand,” he said. “Others can be three pages, because there’s a whole bunch of add-back synergies, prospective treatment of future savings two years down the road, that we haven’t yet thought of, but we think we could get there. Those are areas that we look at.”

McMullan added there’s a “little bit of covenant-lite” deals creeping into the upper middle private-credit market.

The pension fund is looking into setting up a separate department that does work-out debt situations for companies, McMullan said. “When you have a large portfolio and you are playing in the private-debt or just high-yield world, there are accidents that happen,” he said.

But it’s steering clear from cyclical sectors such as oil, he said. This sector is also tricky as Caisse has adopted a climate policy and is trying to reduce its carbon footprint.

“We’ve tried to look at it thinking maybe we could take a bit more carbon risk as long as the return is significantly more, but even that comes into a bit of a clash with the longer-term view on what we should be doing,” he said.
Before I get into James McMullan's warning on signs of an overheated private debt market, I want to bring something to your attention on Alberta.

Paul Desmarais, Chairman & CEO of Sagard Holdings, posted an important message on LinkedIn following up on what Jon Love, CEO of KingSett Capital posted (click on image):

I couldn't resist to reply but I probably shouldn't have as the divisiveness in Canada is really irritating me a lot, to the point where I am fed up with idiots proclaiming we should let Alberta sink or separate. Anyway, these are my thoughts:
It’s quite disturbing when I hear people dismissing Alberta’s economic woes as “nothing, just a bunch of whining Albertans.” Really? When the rest of the country benefited from Alberta’s resource extraction, nobody was complaining but now we have the most vile ecological fundamentalists hijacking our politics, misinforming people and spreading dangerous lies. This statement is so true, it needs to resonate with all Canadians or else Canada as we know it is doomed: “Our citizens in Alberta are suffering economically despite having given the rest of the country billions of dollars in support. It is crazy that we turn our backs to them when we have received so much from them.”
Now, back to James McMullan, head of corporate credit at the Caisse and signs of overheating in some areas of private debt.

This is nothing new to me, I've been around pensions long enough to know one thing, when too much money flows into any asset class, future returns are going to be impacted.

Did I ever tell you about the time I was working at PSP back in 2005 and some board member was dead set on adding commodities as an asset class and I was dead set against it.

The board member kept insisting, so I flew over to London to attend some Barclays conference on commodities and every broker was all over me trying to sell me on the idea once they caught wind that PSP was thinking of including it as an asset class. I came back from that conference convinced it was the top in commodities.

But Mihail Garchev (now at BCI) and I still did the analysis, he crunched the numbers and I did a thorough qualitative analysis, and went back to PSP's board to make the case against commodities.

That board member was so impressed with our analysis, he came to see me after to say we did a great job convincing him against including commodities as an asset class. The basic reasoning was the headwinds from emerging markets were dissipating, we already had commodity exposure through Canadian equities, and most importantly, instead of lowering volatility as everyone was claiming, adding commodities as an asset class would increase it.

We did however recommend active commodity strategies like CTAs but firmly stated we should steer clear of passive indexes.

Anyway, that decision alone saved PSP billions in losses over subsequent years and had PSP taken my warning on the US housing market and the CDO market seriously back in 2006, it would have escaped some of the ravages of the 2008 crisis (not all).

Anyway, the important point I am trying to make to all my readers is don't get swept by hype, always reflect carefully and critically, question everyone, especially your own assumptions. Stop saying "Ontario Teachers' does it, so should we" (Teachers' was heavily invested in commodities back then and I couldn't care less).

Also, go back to read my recent comment on Ray Dalio and whether capitalism is broken. Dalio refers to the glut of money in venture capital and private equity and how this will impact future expected returns.

It's the same thing for private debt. If all the big pensions are playing in one tiny corner of the middle market, you will definitely see erosion in credit quality.

Go back to read my comment on CPPIB bolstering real estate and private debt. James McMullan's counterpart at CPPIB, John Graham, is cognizant of the risks in private debt and more broadly, in the corporate credit market.

Still, CPPIB remains bullish on the US middle-market, where it invests through Antares Capital, which has about $24 billion in assets. Antares is prepared to swoop in to buy assets from cash-strapped lenders when the cycle turns, its chief executive officer said in July.

After leaving PSP, I worked for a couple of years at the Business Development Bank of Canada (BDC), a Crown corporation which acts as a complimentary lender to Canadian banks.

I was in the thick of it when the 2008 crisis hit and let me tell you, a lot of lenders were having a hard time paying back their loans and if it wasn't for the BDC and EDC (and the late Minister of Finance Jim Flaherty who was superb), things would have been a lot worse for the Canadian economy.

The biggest risk to private debt is a severe economic contraction which makes it virtually impossible for lenders to pay back their loans. Sure, pensions have a long investment horizon and very deep pockets so they can ride out a rough patch but if a really bad recession hits, don't kid yourself, private debt will get hit (but distressed debt will be back in vogue).

Anyway, it's probably worth re-posting my notes from the CAIP Quebec & Atlantic conference at Mont-Tremblant which I attended in late September. Here are my notes on the private debt panel:

Capturing the Strength and Momentum in Private Debt and Alternative Credit Growth: The Remarkable Achievements of a Small Asset Class

Wednesday, September 25, 2019, 9:15 AM - 10:15 AM

There are enormous opportunities to be found in private debt and alternative credit growth. In 2018, assets under management globally by private debt funds reached $638 billion, with aggregate capital raised surpassing the $110 billion mark. Hear about the latest developments in asset-back debt, direct lending, and alternative credit. Access the full spectrum of credit instruments to deliver absolute performance while limiting your duration risk and interest rate sensitivity.

Moderator: Vishnu Mohanan, Manager, Private Investments - Halifax Regional Municipality Pension Plan

Theresa Shutt, Chief Investment Officer - Fiera Private Debt
Ian Fowler, Co-Head North America Global Private Finance & President, Barings BDC - Barings
Larry Zimmerman, Managing Director, Corporate Credit, Benefit Street Partners

Synopsis: This morning, we all listened to an interesting panel on private debt, one of the hottest asset classes right now. I came a tad late when they were going over the pros and cons of sponsored versus non-sponsored deals.

In non-sponsored deals, you rely on third party data on quality of earnings and other data.

Theresa Shutt said they focus on corporate credit and companies with audited statements. "If there is trouble, we want to see how management behaves in a downturn, we have good covenants."

She said to ask private debt managers a simple question: "Tell me about your bad months." She added: "Our recovery has been quite high".

I like that, asked Theresa to write a guest comment for my blog on this hot asset class.

Ian Fowler focused a lot of alignment of interests and said to look at two things:

  1. Target return
  2.  Fee structure
He warned "investors are overpaying for beta" and said you can expect 6-8% unlevered return but as the market gets hot, spreads are being compressed, managers are making higher risk loans to meet targeted return, and skimming is occurring where they are using investors' money to generate income on their platform."

Larry Zimmerman also warned investors to beware of private debt managers "building syndication deals".

Theresa Shutt warned not to just talk to principals, "ask about compensation, focus on culture". She said they use ESG in all their underwriting criteria.

I asked the panel how to prepare for another 2008 crisis and they told me to "focus on first not second lien loans" and remain highly diversified, avoiding deep cyclical sectors.

Interestingly, in the US, non bank private debt funds have been very active in the middle market and act to stabilize the market in case of a downturn.

Ian Fowler told us to look at average debt spread, style drift, and leverage.

I need to cover private debt in a lot more detail but Ian told me after that average PE multiples are priced at 12x so there is no room for error. "It's the same thing in private debt, you need to see how deals are being priced and beware of alignment of interests as spreads get compressed and managers try to fulfill their target return".
Keep all this in mind as everyone is singing the praises of private debt. I've never met James McMullan but he seems like a very sensible credit manager who really understands his subject matter in detail and he certainly is aware that some areas of the private debt market are way too overheated.

Below, Kirsten Bode, co-head of pan European private debt at Muzinich, discusses the potential leveraged buyout with Walgreens, her concerns over private markets, where she sees the best opportunities in the market and gender diversity in the financial services sector. She speaks on “Bloomberg Markets: European Open” from the sidelines of the Women in Private Markets Conference in London.

Also, leveraged loan investors are getting increasingly angsty, and their fear may be a harbinger of more pain coming in credit markets. Money managers are plowing into the least risky junk debt they can find and demanding higher yields on tougher credits. That was evident in the pricing of mattress maker FXI Holdings. It priced at a discount to yield 12.625%. Bloomberg's Jonathan Ferro sat down with Kathy Jones of Charles Schwab, Colin Robertson of Northern Trust and BlackRock's Jim Keenan to discuss the cracks emerging in leveraged loans.