Worried about next downturn? US credit funds may offer early clues

Investcorp Credit Management Bdc

12/03/2019 11:00

(Repeats for wider distribution)
    By David Henry
    NEW YORK, March 12 (Reuters) - It seemed like an opportunity
a lender would not want to miss.
    The loan paid 10.25 percent interest which would go up if a
benchmark rose. The borrower was Trident USA Health Services, a
growing company which provided bedside medical testing in
nursing and assisted living centers.
    Trident was buying similar companies across the country
targeting cost savings from consolidation.
    Trident filed for bankruptcy last month. It had taken on too
much debt to cope with reduced Medicare and Medicaid payments,
equipment upgrades and other issues. A new billing system for
the expanded company failed and it never collected millions of
dollars. Trident's lenders face estimated losses of 50 to 100
percent.
    "We were wrong," Michael Mauer, chief executive of CM
Finance Inc,  CMFN.O  one of the lenders, said in a Feb. 7 call
with stock analysts.
    After the Great Recession, regulators squeezed much of the
risk out of U.S. banks. But risk has not gone away. Much of it
now resides in non-bank financial entities, including commercial
loan companies, such as CM Finance, private credit funds, and
structured finance vehicles, many of which have yet to be tested
by a broad recession after a nearly decade-long expansion.
    The borrowers include mid-sized, speculative-grade companies
that have loaded up on debt to fund their expansion. Sometimes
one setback can push them over the edge, as happened with
Trident's botched billing system roll out.
    “We think credit losses will rise,” said Matt Carroll, a
credit analyst at S&P Global Ratings. His reasons: A lot of
money has flowed into private credit, pushing down lending
standards in a benign economy.
    Some $900 billion in non-bank loans to mid-sized companies
sit alongside another $1.1 trillion of speculative-grade loans
that have been made by bank syndicates to larger companies and 
mostly resold to institutional investors. 
    These amounts are dwarfed by the $11 trillion in outstanding
U.S. home mortgage loans and probably are not enough to drag
down the financial system, as mortgages did during the 2007-2009
crisis.
   However, rising non-bank debt has fueled concerns it could
make a recession worse because loan losses could cripple many
non-bank lenders, leaving companies most in need without access
to credit.  urn:newsml:reuters.com:*:nL2N1XY0TV  urn:newsml:reuters.com:*:nL1N1YG2J8 
   "When you have a real recession, the lender will not be
there. So, a lot of these borrowers will be stranded," JPMorgan
Chase & Co chief Jamie Dimon told analysts in January.
    
    SPECIAL STATUS
    The publicly listed funds that lent to Trident are among
several dozen known as business development companies. BDC 
assets have quadrupled since the crisis to $100 billion,
according to data from Wells Fargo analysts. (Graphic: https://tmsnrt.rs/2V2ZCSl)
 Those funds attracted investors by offering yields topping 10
percent because they were making loans that were riskier than
those banks were allowed to make.
     BDCs hold special status under a 1980s federal law designed
to support small business. The law limits their leverage. They
are allowed to bypass taxes by paying out 90 percent of profits
to shareholders. 
    Unlike most non-bank lenders, business development
corporations must disclose estimated values for each loan and
say which ones are going bad. Their reports give analysts
looking for signs of trouble in commercial lending a glimpse
into a bigger pool of an estimated additional $800 billion in
unlisted funds and private accounts managed by many of the same
firms.
    "You can learn a lot by looking at the BDCs for what they
might mean for other private credit," said Carroll of S&P Global
Ratings. 
    In 2013, for example, one such investor called THL Credit
Inc  TCRD.O  made loans, starting at 9 percent, for Charming
Charlie, a retailer of women's fashion accessories arranged by
color in as many as 26 different hues.
    The founder used the loans to buy shares of the business
from a private equity firm and add more stores, according to S&P
Global.
    But the company went too far in stocking the stores with
items of different colors and got stuck with unsold merchandise.
Constrained by its debt, the company ran short of cash to
properly stock the stores and filed for bankruptcy in December
2017.
    THL declined to comment for this story, but in a March 7
call its executives told investors they have diversified their
portfolio to include 42 companies and reduce the risk of losses
like those on Charming Charlie. 
    These days some BDCs are doing better than others. Six of 39
BDCs tracked by Keefe, Bruyette & Woods recently traded at
premiums of more than 10 percent to net asset value, a sign of
good lending records. Eight, however, traded for less than 75
cents for each dollar of net asset value - suggesting they had
enough problems with loans to make investors doubt the values
shown will hold up.
    As BDCs doubled in size since 2013, Refinitiv data shows
levels of debt relative to profits have risen to 4.75 times from
4.2 times for mid-sized companies that borrowed to finance
buyouts, according to Refinitiv data. That, combined with some
lenders willingness to dial up the risk to boost returns, could
spell more trouble ahead.
    "It has become harder for BDCs to deliver compelling returns
without taking more risk," Finian O'Shea, a BDC analyst at Wells
Fargo, said. 
    CM Finance, for example, in the last half of 2018 acquired
loans coming due within two years and issued by low-rated
Techniplas, a supplier of highly engineered plastic parts to the
auto industry. The appeal of the loans? A 14 percent yield. Yet,
last month Standard & Poor’s put a negative outlook on the loans
because of the risk that company will not be able to refinance
them in time.

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U.S. credit funds asset growth    https://tmsnrt.rs/2V2ZCSl
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 (Reporting by David Henry 
Editing by Neal Templin and Tomasz Janowski)
 ((David.Henry@thomsonreuters.com; +1-646-223-6114; Reuters
Messaging: david.henry.thomsonreuters.com@reuters.net))