Private Credit Opportunities – Direct Lending to U.S. Middle Market Companies

February 8, 2017  | by James Meisner, Vincent Kravec

Asset Allocation | Fixed Income | Investment Strategy

Much has been made of the challenges endowment, foundation and nonprofit investors face in achieving a CPI+ five percent return target. One way to improve the probability of attaining this goal is to take advantage of the so-called “liquidity premium.”

The liquidity premium is the extra return demanded by investors when an investment cannot be easily converted into cash for its fair market value. The liquidity premium has fluctuated over time, with recent readings suggesting that it could present a more attractive opportunity now than it has in recent years.

Direct lending is a fixed income opportunity that takes advantage of the liquidity premium in the credit market. Unlike long-lock private investments such as private equity, venture capital and distressed debt, the lending strategy is intermediate term in nature and is often cash-flowing soon after the first capital is called. The loans are typically floating-rate which reduces the duration risk associated with a rising rate environment. Another attractive feature is that many direct lending managers charge fees only on invested capital, which eliminates the “J-curve” problem of traditional private equity. For these reasons, direct lending is often viewed as an attractive complement to private equity investments.

Direct lending is the origination of loans by non-bank lenders, such as asset management firms, to middle market companies in generally higher yielding (below investment grade) transactions. Though definitions might vary, broadly speaking “middle-market” companies that are the target of direct lending managers generate earnings before interest, taxes, depreciation and amortization (EBITDA) of $10 million – $75 million on revenue of $100 – $300 million.

direct lending

By our estimates, investors in direct lending strategies can receive additional compensation of as much as 600 basis points over similar quality high-yield bonds while being more senior in the capital structure and less exposed to the risk of rising rates. Direct lending does require use of modest fund level leverage to achieve these returns, however.

The opportunity for non-bank lenders to enter the space has grown in recent years as a result of changes forced upon the banks by regulators as a result of the Great Financial Crisis. Driven from the space by changes in regulations (Basel III, Dodd Frank/Volker Rule), money center and regional banks have had a reduced appetite for lending to middle market companies, and demand for middle market loans continues to remain high.

The U.S. “middle market” is estimated by some to be $4 trillion in size, and would be the fifth largest global economy based on combined revenue. There is an existing overhang of debt maturities that continue to put liquidity and refinancing pressures on these companies, and private equity sponsors have, by some estimates, in excess of $500 billion of dry powder to put to work in M&A transactions.

So what does one receive exposure to when buying a direct lending portfolio? Following are some key characteristics of direct lending portfolios:

  • Periodic income distributions

  • Floating-rate (LIBOR-based) interest

  • Target loan yield 8%-12% (before fund-level leverage)

  • 2-3 year loan average life (due to refinancing/mergers and acquisitions etc.)

  • Highly negotiated, well-structured legal documents

As money-center and regional banks have stepped away from the sector, significant amounts of capital have entered the space to fill this void, and finding the following characteristics in a direct lending manager can to lead to meaningful and repeatable outcomes. These characteristics include, but are not limited to, disciplined underwriting, better structuring, intensive loan monitoring and workout capabilities.

Disciplined underwriting includes underwriting to exit, not “loan to own”. In addition, the lender minimizes concentrated risks, volatility and cyclical industries. The best lenders also seek to avoid industries and jurisdictions where lenders’ rights could be at risk. Examples of better structures are more robust loan covenants with favorable lending terms and stronger control over amendments than is typically seen in broadly syndicated loans. Typically, the lender can negotiate to have a board observer, and detailed monthly management reporting with key performance metrics chosen by the lender. Intensive loan monitoring includes frequent dialogue with borrowers and private equity sponsors. Finally workout capabilities become necessary if a covenant breach is likely to occur, and it is critical that lenders have the capabilities to manage the workout, restructuring and the bankruptcy process.

In the current low yield environment where income is scarce and interest rate sensitivity is a concern, capturing the liquidity premium through direct lending via floating rate loans may be a compelling building block in constructing a portfolio that will achieve challenging return targets.

Authors

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James F. Meisner shares responsibility for portfolio analysis, manager identification, due diligence, and investment monitoring. Prior to joining Commonfund in 2004, he spent 12 years at RBS Greenwich Capital, where he was Managing Director and Research Manager for the Strategies Group. Jim provided analytical and strategy support for fixed income sales and trading desks for products including: Treasuries, Agencies, MBS/ABS/CMO, interest rate swaps/options, and international financial futures/options. Prior to that, he was Senior Vice President, Manager of Futures and Options Research, Yamaichi America; Director, Manager of Financial Futures and Options Research, Merrill Lynch Capital Markets; and also held marketing and research positions at The Chicago Corporation and Prudential-Bache Securities. Jim began his career in the financial markets in 1981 at the Chicago Board of Trade, where he was involved in the introduction of options on bond futures, first as staff economist and later as marketing manager. Earlier, he was an Instructor in Statistics and a Research and Teaching Assistant in the Graduate School of Business, University of Chicago. He received a B.A. in mathematics from the University of Chicago, and a M.B.A. in finance and completed coursework and examinations for a Ph.D in econometrics from the Graduate School of Business, University of Chicago.
James F. Meisner
Managing Director
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Vincent Kravec is a generalist, supporting all areas of the Fixed Income and Commodities Team. Prior to joining Commonfund in 2006, Vincent was with Lazard Asset Management from 1999 through 2006 most recently as a member of the Fixed Income operations staff. While at Lazard he was responsible for allocating trades and resolving trade problems for corporates, treasuries, municipals, asset backs and FX trading desks. He was also a supervisor in Fixed Income Accounting and a trading assistant on the Emerging Markets team. Previous experience includes positions at Morgan Stanley, Alliance Capital and Evaluation Associates. Vincent earned his M.B.A. in from New York University′s Stern School of Business and his B.A. from Fairfield University. He is also a CFA charterholder.
Vincent Kravec
Director, CFA

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Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund managers. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund Group’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund Group fund. Such statements are also not intended as recommendations by any Commonfund Group entity or employee to the recipient of the presentation. It is Commonfund Group’s policy that investment recommendations to investors must be based on the investment objectives and risk tolerances of each individual investor. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund Group. Commonfund Group disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.