Build Me Up, Buttercup, Don’t Break My Heart: Private Debt Market Realities

By David Saija, Senior Portfolio Manager

At a glance

The 1968 hit “Build Me Up Buttercup” by the Foundations, which narrates a tale of unrequited love, where the subject of the song gives false hope by promising to do certain things but ultimately failing to do so, and by giving the narrator confidence, and then letting them down, has its parallels with the dynamics of the private credit market.

Just as the song’s upbeat melody clashes with its melancholic lyrics, the private debt market often balances between optimism and the harsh realities. Deployment targets often cloud credit judgement, with lenders balancing between deploying funds and setting adequate terms and conditions and completing sufficient due diligence to ensure full repayment on maturity of the loan. This is where lender confidence and optimism, where they instil trust and faith in borrowers, is met with the realities of loose terms and high leverage. It often doesn’t end well.

“Why do you build me up (Build me up)
Buttercup, baby
Just to let me down? (Let me down)
And mess me around…”

“So build me up (build me up)”
– The M&A Landscape in Australia and current trends

Lending isn’t anything new and can be traced back thousands of years. Regardless of the era, lending has consistently been governed by terms and conditions that borrowers must adhere to, including specifications on repayment form and timing. This fundamental aspect remains unchanged today. However, as has been the case historically, the availability of funds and willingness to lend can fluctuate, leading to shifts in the lending landscape.

2023 marked a significant decrease in M&A transactions compared to previous years, particularly in terms of private equity embarking on acquisitions. At the same time, Australia experienced an increase in lenders entering the private debt landscape, including newly established local outfits looking to raise capital from investors, as well as subsidiaries of European and/or North American managers seeking to expand their footprint in the region.

One of the key attractions of the Australian market is the large pool of compulsory superannuation savings, estimated to be in excess of A$3.5 trillion. However, tapping into these funds is very difficult, with established relationships and client engagement, track record and fee structures being a key focus.

When you put this all together, you get a period of limited supply of new loans coming to market, with more lenders looking to participate in the market (increased demand) being fuelled by strong investor interest in the asset class.

This has led to some interesting developments in the Australian private debt market. As is the case with most markets, risk tolerance and return objectives can vary among market participants which can lead to various ramifications, particularly in periods of increasing demand and limited supply.

For example, some market participants have a high target return (yields in the low-to-mid-teens for example), with a higher risk tolerance which leads to many of these market participants targeting transactions that fit outside more traditional Australian leveraged buyouts. “Second lien”, “mezzanine”, and “Holdco” are terms often associated with higher yield (and higher risk) structures relative to the more conservative bank deals and to a lesser extent, Term Loan B and Unitranche transactions that are more prevalent in the Australian private debt market. However, this high yield market is very limited in Australia and even more so over the last 12 months due to subdued M&A activity. This has prompted some investment managers to be more creative as they seek to meet their deployment targets.

“So build me up Buttercup, don’t break my heart”
– Balancing confidence and risk

When aiming for a specific level of return, various measures can be taken, typically involving relaxed terms and giving up some protections. This might include granting borrowers greater flexibility, allowing higher leverage, doing away with covenants, and granting other liberties, such as capitalising interest. Lenders are displaying confidence and placing trust in borrowers, with the hope that borrowers won’t disappoint (or break their heart).

Providing greater flexibility for strong borrowers in sound industries with a leading market share may be acceptable in certain situations, however one should exercise a great degree of caution in doing so and extending flexibility to all borrowers is not appropriate and contrary to investors’ best interests. Such leniency could ultimately result in heartbreak.

“Although you’re untrue, I’m attracted to you all the more”
– Addressing leverage

Leverage is another important consideration when looking at a private debt transaction and there are multiple ways to consider this. Not all businesses and industries can sustain the same level of leverage, with cyclical businesses and industries for example generally not able to leverage their businesses very highly given the variability of cash flows and profitability.

There is also the value of the business to consider, which provides an indication of the equity buffer available to debtholders. For example, if a business has an enterprise value (EV) multiple of say 10x earnings, and the leverage being utilised to acquire the business is 4x, there is a significant equity buffer of 6x. This buffer can move over time based on what happens to leverage over the life of a transaction (earnings could decline resulting in higher leverage, or the company could raise additional debt which would also increase leverage) as well as what happens to the value of the company which can fluctuate through economic and market cycles. From a lending perspective, a large equity buffer is more desirable than a small equity buffer as it provides headroom in an enforcement scenario and will lead to a higher recovery.

“You never call baby, when you say you will”
– The importance of covenants

This ties in with the importance of covenants, which impose restrictions on borrowers, such as maximum leverage or minimum interest cover ratio (or ICR). These covenants must be complied with by the borrower, or they trigger a breach of the covenant, leading to an event of default and allowing the lenders to demand full repayment of the loan.

Without covenants, a lender could find itself in the situation where leverage continues to increase to the point where leverage is higher than the enterprise value of the business, with the lender effectively unable to do anything (due to the absence of covenants) until the borrower defaults on payment. You can wait by the phone, but I don’t think they are going to call you. At this point, leverage would likely be much higher than the value of the business, resulting in a loss of capital to lenders as they experience a sub-par recovery rate.

Contrastingly, with covenants in place, breaches can be addressed through “equity cures,” where fresh equity capital is injected to reduce debt and align leverage levels with compliance. Importantly, covenants facilitate lender-borrower engagement to rectify issues or initiate enforcement proceedings where assets can be sold to repay the outstanding debt before leverage escalates, safeguarding their recovery. Having covenants in place means they have to call!

“But I love you still – I need you!”
– When deployment pressure clouds judgement

Another consideration is the serviceability associated with a certain leverage level. The higher the debt levels held, the greater the cash flow required to service the outstanding debt, particularly in the situation where base rates are increasing, as has been the case over the last two years. The sensible approach would see borrowers right-size the level of debt to ensure ample coverage, however, this isn’t always the case.

An unwelcome trend that has emerged of late has seen leverage levels increase to the point where serviceability is very tight, but rather than reduce the quantum of debt, the terms have been modified to incorporate pay-if-you-can terms (referred to as PIK or Payment-In-Kind) that sees part of the debt requiring interest to be cash-paid and part of it that capitalises (where the interest gets added to and increases the debt balance payable at maturity). Revolution views this as affording the borrower too much flexibility with the capital structure perhaps not being suitable for the borrower. But certain lenders can look past such a material shortcoming (“But I love you still”) as they have pressure to deploy capital (“I need you”).

“I’ll be home, I’ll be beside the phone waiting for you”
– Where does this leave the market today?

Revolution’s take is that we have been through a period of soft M&A activity with very few deals coming to market while at the same time, the market has seen the entrance of a number of new participants. Importantly, the mandates of these new participants are not necessarily homogenous¹, resulting in varied practices across the private debt universe. This gives some lenders the opportunity to flex terms and conditions to tailor transactions to reach their target returns, while at the same time materially increasing the levels of risk for investors.

For investors, the prevalence of weaker terms and conditions, increased leverage, and the absence of covenants alongside the emergence of PIK loans represent heightened downside risk. These factors not only amplify the probability of default, but also exacerbate potential losses in the event of a default, as protections are eroded. Consequently, there is a greater propensity for situations to deteriorate further than would normally be the case. However, despite the challenges, Revolution maintains a vigilant stance ― understanding the dynamics of the market and prioritising financial discipline to navigate the landscape effectively, ensuring a prudent approach to private market transactions.

Hearts will certainly be broken, but Revolution knows the game.

“But I love you still
I need you (I need you)
More than anyone, darlin’
You know that I have from the start
So build me up (Build me up)
Buttercup, don’t break my heart.”

1. With Revolution being the only asset manager (to our knowledge) offering investors with a diversified exposure to three sleeves of Australian and New Zealand private debt through Private Company and LBO, Asset Backed Securities and Commercial Real Estate Debt, which allows it to find the best relative value across its investment universe at any point in time.

Important Information

This information is for institutional and professional investors only and has been prepared by Revolution Asset Management Pty Ltd ACN 623 140 607 AFSL 507353 (‘Revolution’) who is the appointed investment manager of the Revolution Private Debt Fund II and the Revolution Wholesale Private Debt Fund II (together ‘the Funds’). Channel Investment Management Limited ACN 163 234 240 AFSL 439007 (‘CIML’) is the Trustee and issuer of units for the Funds. Channel Capital Pty Ltd ACN 162 591 568 AR No. 001274413 (‘Channel’) provides investment infrastructure services to Revolution and Channel and is the holding company of CIML. None of CIML, Channel or Revolution, their officers, or employees make any representations or warranties, express or implied as to the accuracy, reliability or completeness of the information, including forecast information, contained in this document and nothing contained in this document is or shall be relied upon as a promise or representation, whether as to the past or the future. Past performance is not a reliable indication of future performance. All investments contain risk. This information is given in summary form and does not purport to be complete. To the extent that information in this document is considered advice or a recommendation to investors or potential investors in relation to holding, purchasing or selling units in the Funds please note that it does not take into account your particular investment objectives, financial situation or needs. Before acting on any information you should consider the appropriateness of the information having regard to these matters, any relevant offer document and in particular, you should seek independent financial advice. For further information and before investing, please read the relevant Information Memorandum available on request.