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Private credit is an integral, evolving part of the Australian debt market. While still only making up a relatively small portion of the total lending industry, private capital's rapid growth, presence in riskier and more complex deals, and attractiveness to investors gives it an outsized impact on debt markets as a whole.
But with this growth comes greater complexity - and scrutiny. A major challenge facing private credit lenders is the management of non-performing loans (NPLs), particularly in high-profile or distressed situations. As investor expectations rise and regulatory oversight intensifies, lenders must also navigate the added layer of fund financing arrangements, where covenant compliance can directly impact how NPLs are handled.
Flexible terms and speed of execution lie at the heart of private credit's appeal and growth. These features are appealing to borrowers in both stronger and weaker financial positions: in the former case, because they offer more flexible and non-public terms, and in the latter case, because they provide an ability to consider complex security structures and borrowers executing turnarounds and business improvement. Borrowers and their sponsors also value the ability to build ongoing relationships with private credit lenders for good times and bad. Investor demand for private credit is also strong, with allocators large and small attracted to higher returns than traditional debt instruments and lower volatility than equity investments.
However, flexible structures and meeting demand to deploy capital can create issues when borrowers face financial challenges. Private credit lenders are under increasing investor, media and regulatory scrutiny over their management of non-performing loans (NPLs), particularly to high-profile distressed borrowers. In addition, an increasing number of private credit lenders are entering into fund financing facilities secured over their loan portfolios and have to consider compliance with covenants under those facilities when managing NPLs.
Most private credit lenders, in the first instance, will adopt a cooperative approach to addressing a borrower's financial challenges, and a pre-enforcement workout process, if feasible, will generally yield a better outcome for all stakeholders. However, particularly where there are issues with the borrower's management capacity or question marks over the value or ability to realise collateral, lengthy workouts can become counterproductive. Long processes strain relationships with management, junior lenders, employees and trade creditors and can make an enforcement significantly more challenging if it is ultimately required. While a decision to enforce is not one to be taken lightly, if there are fundamental challenges facing the borrower, it is generally preferable to confront these issues sooner rather than later. As, unlike commercial banks, private credit lenders often do not have dedicated workout teams, it can be a good idea to seek early advice from restructuring advisors and leverage their experience to ensure the workout strategy is robust from the outset.
Lender support of borrower sale processes needs to be approached with particular care. While a solvent sale process often can yield a superior outcome to one in administration, lenders should ensure that borrowers are appropriately advised and have appropriate expectations of the valuation of the assets to be sold. Unstructured sales processes seeking unrealistic valuations can have the effect of spoiling the market, making a subsequent sales process following enforcement more difficult.
While active management of NPLs is clearly in the interests of lenders and their investors, care must be taken, especially in protracted pre-enforcement workouts. With the introduction of the safe harbour defence from insolvent trading, borrowers are becoming increasingly comfortable to take advantage of a lender's forbearance to attempt to resolve their financial distress solvently.
While such workouts are often appropriate and a helpful initial response to an NPL, lenders and their advisors must resist exercising a significant degree of management control over businesses during these processes and limit their role to protecting their issues as lenders. Micromanaging borrowers in a workout exposes lenders to a variety of claims, including shadow director claims for insolvent trading and attacks on additional credit support provided as consideration for forbearances.
A practical strategy to manage this risk is to encourage, or require as a condition to a waiver, that a borrower engage professional restructuring advisors (financial and/or legal) with whom the lender is comfortable working with across the table. The involvement of appropriate advisors, whether in a formal safe harbour advisor capacity or otherwise, is beneficial to both parties, and can improve both substantive outcomes (e.g. by ensuring a borrower sales process is realistic and effective) and protect lenders from liability (e.g. by avoiding the need to micromanage borrowers to meet forbearance milestones and other lender requirements).
The risk of lender liability does not end on the commencement of enforcement. A lender's receiver is subject to heightened duties in respect of their exercise of the power of sale under section 420A of the Corporations Act, and an enforcement process led by a receiver can create complications should the lender wish to pursue a debt for equity swap or finance an acquirer in an enforcement sale process. This complexity is heightened when dealing with unusual collateral or complex security or intercreditor structures which are a feature of many private credit deals.
While the appropriate enforcement mechanism will depend on the circumstances of the facility, we are increasingly recommending administration-led enforcement processes as an alternative to receivership, especially when a debt for equity swap is a possible outcome.
| Case study: Successful NPL management |
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Corrs recently advised a private capital lender on the successful management and workout of a senior loan facility to a financial services business. The borrower had suffered from a breakdown in relationships between the directors and shareholders which risked the long-term viability of the business, and the lender's ability to recover their loans. The lender took proactive action to explore whether a solvent transaction led by directors was possible, providing the borrower with a number of opportunities to explore alternative resolutions. However, on forming the view that this path was not capable of execution, it took enforcement action to appoint voluntary administrators to the borrower's holding company. By acting while the borrower's business was still well-functioning operationally, the administrators were able to continue to trade with the assistance of management through its subsidiaries using available cash flow and successfully sold the business, providing a full recovery for the lender and preserving the business as a going concern. A lender with a more conservative approach to NPL management may have provided management with more opportunities to attempt to resolve the facility solvently. However, doing so would have exposed the lender to risk of further asset value degradation (both through management issues affecting day-to-day operations and the impact on the market for business of an extended management-led sales process) and potentially increased the costs of enforcement, particularly if a degraded business required funding to continue trading in administration. |
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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