The private debt market has been around for decades, but today’s popularity was forged in the wake of the Global Financial Crisis. Back in 2008, as banks retreated, the sector witnessed an accelerated process of disintermediation, which saw a wide field of private debt funds stepping into the traditional role of banks.

Against a backdrop of ultra-low rates and anaemic growth, institutions were increasingly drawn to the diversification benefits, defensive characteristics and potential for stable returns that private market debt offered. In North America, during the GFC and other crises, we witnessed funds with vintages starting in times of turmoil outperforming on a median-net IRR basis. Whether this performance can be repeated in the wake of Coronavirus lies in the shape of the recovery.

Governments are doing everything they can to keep liquidity flowing and we have already seen the leveraged finance market recover a great deal since March. However, this means that while terms are certainly better than they were, this is not a screaming buyers' market in the way a prolonged period in 2008 and 2009 was.

Contrasting now to then, governments and central banks are now old hands at stimulus. The stimulus response to this crisis is multiples larger than 2008. Markets have come to understand and expect government support for asset valuations and, as a result, markets have snapped back far faster than the real economy. My fear is the recovery will be much slower than markets are expecting, and this could be a very poor vintage (return on investment) for strategies with too much market beta.

As funds deploy the vast majority of their capital, very little room is left for follow on in the more mature vintages. We have also seen funds take on additional leverage, though this is more typical in the US, or the smaller USD sleeves of the European funds. The European market is less aggressive than its US counterpart, due to a combination of decreased investor appetite for risk and more stringent regulation.

The race to deploy has now led to a situation, under acute market stress, where the requisite liquidity is not available to provide additional support to assets. This has led debt funds to search for NAV fund financing facilities to provide additional capital to these older vintages. Particularly, as this is an area that often doesn’t fall under government stimulus.

This raises a number of important questions. If a bank cannot step in, what are a fund's alternatives and the implication for investors? Also, can newer vintages from the same manager support deals in older funds? And how is this conflict managed? 

We must also consider the relationship status between lenders and borrowers in this market. If we contrast the situation in 2008, where the lender was probably a key relationship bank, to now, where it may be a boutique direct lender – does this impact the sponsor's incentive to provide further equity support?

Black swan moments have a habit of revealing conflicts and paradoxes that exist across financial markets. Some lingering concerns within the private debt space will be exposed as the tide recedes.

For example, a conflict of interest could arise if equity and credit funds are managed by a private equity firm invested in the equity and debt of the same company. This will be exacerbated as liquidity begins to bite. In principle, private credit investors could face the risk of unexpected losses in the event of debt restructurings unduly favourable to equity holders. Moving forward, this should be more closely considered from a risk perspective when looking at private debt.

Before Coronavirus, policy makers were sounding the alarm about weaker covenants and signs of more reckless lending – resembling pre-crisis behaviour – creeping back into the market. While market guardians must remain ever vigilant around lending and avoid stripping out important investor protection, in a liquidity squeeze, covenant light loans may paradoxically improve the lot of some investors.

Ironically, looser covenants, particularly common in the US, could turn out to be a blessing in disguise for some deals which would otherwise be breaching now, giving businesses breathing room until their next refinance. For other deals this lack of covenants could allow value to bleed to equity investors before the creditors can ever get them around the table.

High leverage and loose terms do not have to mean a bad deal. But in a highly competitive market where participants begin to stretch risk budgets, we will find out which deals were priced for perfection and which were prudently downside protected.

This crisis will not hit all managers equally. Certain niche strategies and sector focuses may be less impacted, while others could experience real pain. The outcomes will not always be fair – we are seeing starkly different deal level outcomes. For example, one healthcare deal could be by largely NHS backed and able to ride out the storm, while another could have more private business and face decimation.

Or, for example, one real estate lender might have mostly offices and logistics, while another has more retail. When those deals were printed, they were different deals with different risk levels, but many people will not have foreseen quite how stark the difference in risk has turned out to be.

One thing is clear, there will be winners and losers. The winners will be market leaders with strong niches, origination and risk management. The ‘me too’ strategies may struggle. Smaller lenders may also be less able to find follow on to support existing deals and be less well positioned at the negotiating table.

I see an acceleration of the industry polarising, with more LP flows going towards the largest managers and smaller niche lenders that have delivered uncorrelated returns or upside through this test, and the middle will continue to be squeezed.

There will also be stark questions for the sector post-crisis. Did private debt managers price risk appropriately by providing leverage to private equity firms? And was the reach for returns structurally prudent?

Meanwhile, for private funds facing a liquidity squeeze, there are fortunately options to navigate the turmoil and unexpected obligations. By finding the right funding partner and range of solutions, they can bridge liquidity gaps by borrowing against assets or investor commitments to ensure they navigate a safe course through a fund’s full life cycle.