It is a fact that the process of lending and investing has changed and become much easier as a growth mechanism. There are a myriad of reasons and specifics, such as the explosion of private equity, disintermediated bank lending principles after the financial crisis, and the migration of traditional bank lenders to higher earning situations. And there just happens to be a record amount of investable cash lately.
One can argue that the largest institutional asset accounts are so diversified and much larger than the mass of investors that there are few investors to buy their assets. Maybe, as Howard Marks at Oaktree hypothesized in a discussion with his son last year, that we should hold onto assets we have the most faith in for a longer time rather than selling at “price targets.”
One of the most powerful organizations that have emerged over recent years is the limited partner boards (LPs) that monitor actions taken by their private equity managers. If one fund sells an asset to another, an LP may lose the bid or offer spread, simply selling an older asset and paying another management fee for the same asset in a different fund. The pandemic crisis saw a large number of funds launched that depleted their investment period and extensions. This is why we monitor fund activity based on structural terms.
Evaluating the Ratio Between Yield and Risk
Clearbrook has moved some client money into the Business Development (BDC) space, which pools capital to buy middle market loans. These entities are friendly lenders who orient themselves to work with companies where they can act more like a partner than a banker. Historically, they yield less than riskier assets, employ some level of leverage, but do not have the same structural impediments that other private funds do. We also like selective Collateralized Loan Obligations – collections of loans similar to the BDC structure but with more analytical and contractual restrictions.
High-yield debt is now really “no-yield” debt as the companies taking the financing route have materially different goals and strategies than the loan markets we have discussed. A significant example is companies that issue high-yield debt usually having a large amount of equity that can be shorted, leveraged, or in some way, positioned negatively to the debt. In addition, high-yield bonds may be “lent” by those who want to see the company do poorly and are aligned against them. It is a different world for traditional securities.
Understanding the Investment Potential of Direct Lending
Direct lenders make loans to businesses without an intermediary or investment bank. It is private debt, mainly positioned as a first lien loan made to middle-market companies (between $50 million and $1 billion in annual revenue). Middle-market companies account for one-third of US private-sector GDP and employment and also play a significant role in Europe. These loans typically finance growth investments, recapitalizations, leveraged buyouts (LBOs), and mergers and acquisitions (M&A).
Investing in direct lending can generate attractive returns with less risk and volatility than syndicated loans. Take advantage of leveraging debt financing needs in middle-market companies facing maturity and dealing with private equity sponsors that control deals using their capital. It is possible to reduce risk with better access to management when you design a creditor-friendly structure. There are tax-efficient investment solutions for limited partners in a variety of geographies, but you need to use your portfolio manager for creative solutions to complex lending situations.
Structuring the loan can include:
- Interest rates ranging above a reference rate, such as Libor or the Secured Overnight Financing Rate (SOFR)
- Shorter terms to maturity than high yield bonds, usually between three and four years
- Greater maintenance and loan value protection with built-in financial conditions, such as keeping a specific ratio of debt
- Additional returns through an illiquidity premium for the additional risk of tying up capital in a less liquid asset
- Returns uncorrelated with public debt and equity markets
Lending for Consistent Yield and Reduced Risk
Direct lending portfolios can generate returns similar to other credit investments but with less risk. It is possible to gain exposure to private-equity-sponsored deals without assuming the same level of risk. The advantages compared with many other types of debt investments include:
- Greater protection from rising interest rates due to shorter loan duration
- Higher priority and security pays the loan out first in default
- Increased protections with collateralized loans that are high in the capital structure
- Lower potential losses in default due to an average recovery rate of 75%
- More yield spread per unit of leverage compared to first lien LBO loans, and other warrants and conditions to enjoy benefits along with better risk protection
- More control in a relationship-based lending model with more access to the company before and after the deal, and greater power over terms and structure
- Higher illiquidity premium secures higher origination fees and coupon rates compared to BSLs
- Lower volatility than high-yield bonds or more liquid loans
- More diversified portfolios by accessing opportunities unavailable to those limited to the public markets
Lending and Investment Options
Naturally, the number of options available can overwhelm inexperienced investors. Problems may arise at any stage in the lending process. Be sure to have a professional advisor with a strong deal sourcing pipeline, an understanding of fund-level leverage, and refinancing risk. It takes research, due diligence, sector-specific expertise, staff, and resources to structure the investment correctly. It is necessary to address legal, tax, and regulatory concerns as well. Clearbrook portfolio managers continuously monitor the investment to identify and mitigate potential problems or navigate restructuring.
Sources:
Oaktree Capital, Direct Lending: Benefits, Risks and Opportunities, Key Points,
https://www.oaktreecapital.com/insights/oaktree-insights/strategy-primers/direct-lending