The essential resource for navigating the growing direct loan market
Private Debt: Opportunities in Corporate Direct Lending provides investors with a single, comprehensive resource for understanding this asset class amidst an environment of tremendous growth. Traditionally a niche asset class pre-crisis, corporate direct lending has become an increasingly important allocation for institutional investors--assets managed by Business Development Company structures, which represent 25% of the asset class, have experienced over 600% growth since 2008 to become a $91 billion market. Middle market direct lending has traditionally been relegated to commercial banks, but onerous Dodd-Frank regulation has opened the opportunity for private asset managers to replace banks as corporate lenders; as direct loans have thus far escaped the low rates that decimate yield, this asset class has become an increasingly attractive option for institutional and retail investors.
This book dissects direct loans as a class, providing the critical background information needed in order to work effectively with these assets.
* Understand direct lending as an asset class, and the different types of loans available
* Examine the opportunities, potential risks, and historical yield
* Delve into various loan investment vehicles, including the Business Development Company structure
* Learn how to structure a direct loan portfolio, and where it fits within your total portfolio
The rapid rise of direct lending left a knowledge gap surrounding these nontraditional assets, leaving many investors ill-equipped to take full advantage of ever-increasing growth. This book provides a uniquely comprehensive guide to corporate direct lending, acting as both crash course and desk reference to facilitate smart investment decision making.
Overview of US Middle Market Corporate Direct Lending
This book focuses on the investment opportunity in US middle market corporate direct lending (or direct loans), a large and rapidly growing segment of the global private debt market. Direct loans are illiquid (nontraded) loans made to US middle market companies, generally with annual earnings before interest, taxes, depreciation, and amortization () ranging from $10 million to $100 million. These middle-market corporate borrowers are of an equivalent size to those companies found in the Russell 2000 Index of medium and small stocks but, in aggregate, they represent a much larger part of the US economy compared to the Index. The US corporate middle market includes nearly 200,000 individual businesses representing one-third of private sector gross domestic product GDP and employing approximately 48 million people.1
Exhibit 1.1 illustrates where direct corporate lending fits within the multiple sources of long-term debt financing provided to US companies as of December 31, 2017. Long-term debt financing to US companies totaled approximately $10 trillion. By comparison, equity financing to US companies totaled approximately $24 trillion.2
EXHIBIT 1.1 Breakdown of the $10 trillion US corporate debt market.a
Traded, investment-grade bonds represent almost one half of corporate debt financing, but this debt is issued by the largest US companies. High yield (non-investment-grade) bonds and bank loans represent one-half of investment-grade bond issuance. These companies are also larger, with EBITDA over $100 million where scale allows them to access the traded broker markets. Bank commercial lending, the market where direct lenders compete, is $2.1 trillion in size. The US government, through government-sponsored enterprises (GSEs) and agencies, makes direct loans to companies in generally depressed or subsidized industries, such as agriculture. These loans are estimated at $0.6 trillion.
The size of the direct lending US middle market loans is estimated to equal $400 billion, based upon Federal Reserve data and other sources. While small compared to traditional sources of corporate financing, the direct loan market has significant potential for growth if it can continue to claim market share from the bank C&I loan business.
THE RISE OF NONBANK LENDING
Commercial banks have been the traditional lenders to US middle market companies. The Federal Reserve reports that US banks hold roughly $2.1 trillion in commercial and industrial (C&I) loans on their balance sheets, which is mostly comprised of middle market business loans. Banks also make loans to larger companies that are not held on their balance sheets. Instead these larger loans are sold and syndicated across many investors, which are subsequently traded as private transactions in the secondary market. These traded loans are also referred to as broadly syndicated loans (s), also known as leveraged loans. The size of the leveraged loan market is roughly $1 trillion, or half the size of bank C&I loans. These larger, traded bank loans have become very popular among institutional and retail investors through pooled accounts, mutual funds, and exchange-traded funds (ETFs), providing a yield advantage to investment-grade bonds while maintaining daily liquidity.
Loans to middle market companies are too small for general syndication and therefore are held by the originating bank. The investment opportunity in middle market loans for nonbank asset managers principally came about as an outcome of the 2008-2009 global financial crisis (), and the years following, when increased capital requirements and tighter regulation on corporate lending made holding middle market corporate loans more expensive and restrictive for most banks. As banks decreased their lending activity, nonbank lenders took their place to address the continued demand for debt financing from corporate borrowers.
Direct loans are typically originated and held by asset managers that get their capital from private investors rather than bank deposits. Asset managers are regulated by the Securities and Exchange Commission and are not subject to the same investment restrictions placed upon banks. Investors are primarily institutional rather than retail, representing insurance companies, pension funds, endowments, and foundations. Retail investors have had access to direct loans mainly through publicly traded business development companies (s), which are discussed in Chapter 12.
There are approximately 180 asset managers in the United States that invest in direct middle market corporate loans. Many of them began direct lending during and soon after the GFC and recruited experienced credit professionals from banks that either went into bankruptcy (Bear Sterns, Lehman Brothers) or had their activities sharply curtailed. GE Capital, the financing arm of General Electric, also faced important financial problems during the GFC. GE Capital, through its subsidiary Antares, was at one point the largest US nonbank lender. The subsequent exodus of credit and deal professionals provided significant intellectual capital to the nascent nonbank lending industry.
While banks continue to hold a key advantage over asset managers by having a low cost of funds (i.e., bank deposits), this is offset by higher capital requirements, which ties up shareholder equity, and restrictions on the type of business loans that can be made by banks and the amount of leverage they can offer to borrowers. While these regulations may ease over time, particularly with the more business-friendly Trump administration, which could entice banks to re-enter the market, the loss of talent during and after the GFC, and subsequent weakening of banks' relationships with borrowers, makes this a challenging prospect.
Finally, the growth of nonbank lending has also been helped by a new type of corporate borrower, the private equity sponsor. Private equity has seen steady growth since it began over 30 years ago but its role in the US economy has picked up significantly since the GFC, particularly in the middle market. These private equity-sponsored companies are professionally managed, use debt strategically in financing, and require timeliness, consistency, and flexibility from lenders as well as attractive pricing. The advent of direct lending by professional asset managers has given private equity sponsors an alternative and preferred source of financing. Currently roughly 70% of direct loans are backed by private equity sponsors.
DIRECT LENDING INVESTORS
Investor interest in middle market direct lending has been driven by several factors. First and foremost is their attractive yields, ranging from 6% for the least risky senior loans to 12% for riskier subordinated loans. These yields compare with 2-3% for liquid investment-grade bonds, as represented by the Bloomberg Barclays Aggregate Bond Index, a widely used investment grade bond index, and 4-5% for broadly syndicated non-investment-grade loans, as represented by the S&P/LSTA Leveraged Loan Index, an index used to track the broadly syndicated loan market.
Investors are also attracted to direct loans because coupon payments to lenders (investors) are tied to changes in interest rates and have relatively short maturities (typically five- to seven-year terms, which are typically refinanced well before the end of the loan term). The floating-rate feature is particularly important in periods of rising interest rates. Interest rates for direct loans are set by a short-term base rate (or reference rate) like three-month London Interbank-Offered Rate (Libor) or US Treasury bills, plus a fixed coupon spread to compensate for longer-term default risk and illiquidity. Bank loan investors will see their yields increase as interest rates rise through quarterly adjustments to their base rate. In many respects, rising interest rates are beneficial for direct loan investors.
Conversely, most bond funds primarily hold fixed-rate securities, whose yields do not adjust to rising interest rates. Instead rising rates cause bond prices to fall, in line with the duration of the bonds. A typical bond mutual fund has a five-year duration, a measure of average bond life. In this example, if interest rates for bonds with a five-year weighted average duration rise one percentage point, the bond fund will experience a 5% decline in value (five-year duration multiplied by 1% interest rate increase), offsetting any benefit from increased yield. Direct loans have only a three-month duration and a one-percentage-point increase in rates will have only a temporary 0.25% (25 basis point) price decline. The direct loan yield will reset at the next calendar quarter and its value will return to par.
Direct loans generally have a shorter life than their five- to seven-year maturities suggest, which can be both good and bad. The average life of a direct loan has averaged approximately three years, much shorter than their stated maturity due to their being refinanced from corporate actions, such as acquisition of the borrower by another company, or prepayment by the borrower to get a lower interest rate. The good news is that direct loans are not as illiquid as their...