46% 41% 13%
INSIGHTS: DIRECT LENDING
DIRECT LENDING CONTINUES TO ATTRACT YIELD STARVED INVESTORS By Caroline Rasmussen
November 16, 2016
North American-focused private direct lending funds secured a combined $17 billion in commitments in 2015, contributing to a 144% rise in aggregate capital raised for the strategy from 2012-2015.1 The popularity of direct lending, an important component of the private debt market, looks set to continue, with 46% of investors intending to commit more money to private credit this year than in 2015, and 52% of investors planning to increase their private debt allocations in the longer term (Figures 1 and 2).2
SIGNIFICANT SUPPLY-DEMAND IMBALANCE The surge of interest in direct lending may give rise to concerns that the opportunity is becoming saturated, as investors have
FIGURE 1
INVESTORS’ EXPECTED CAPITAL COMMITMENT TO PRIVATE DEBT FUNDS IN 2016 COMPARED TO 2015
directed $51.4 billion into North American-focused direct lending funds over the past three years.3 However, the supply-demand imbalance remains significant, favoring experienced lenders. As of
MORE CAPITAL IN 2016 THAN 2015
the end of 2015, North American-focused private equity buyout
46%
firms held approximately $276 billion in dry powder.4 Assuming an average equity contribution of 40% per deal, the market is facing over $400 billion in loan demand from private equity sponsors. Combined with approximately $800 billion in looming leveraged
SAME AMOUNT OF CAPITAL IN 2016 AS IN 2015
41%
loan market maturities through 2022, the overall demand for debt financing in North America over the next five to seven years is about $1.2 trillion.5 This large financing gap does not assume any growth in the underlying corporate market, or take into account any further decreases in the proportion of senior debt capital supplied by banks, which have been retrenching from the middle
LESS CAPITAL IN 2016 THAN 2015
13%
Source: 2016 Preqin Global Private Debt Report
market due to regulatory changes.
iCapital Network
441 Lexington Avenue New York, NY 10017
212 994 7400
www.icapitalnetwork.com
FIGURE 2
FIGURE 3
COVENANT-LITE VOLUME AS A PERCENT OF TOTAL INSTITUTIONAL VOLUME
INVESTORS’ INTENTIONS FOR THEIR PRIVATE DEBT ALLOCATIONS IN THE LONGER TERM
COVENANT-LITE VOLUME AS A PERCENT OF TOTAL INSTITUTIONAL VOLUME(1)
80%
INCREASE ALLOCATION
52%
70% 60% 50% 40%
MAINTAIN ALLOCATION
DECREASE ALLOCATION
40% 8%
30% 20% 10% 0% 2010
2011
2012
2013
2014
2015
Source: S&P LCD US Interactive Volume Report
Source: 2016 Preqin Global Private Debt Report
SO WHAT EXACTLY IS DIRECT LENDING?
levels of high yield and covenant-lite issuance in recent years,
Direct lending is the provision of debt financing on a private basis
its way into many portfolios.
directly between a non-bank lender and the borrowing company. This type of lending is distinct from the traditional sources of debt
shown in Figure 3, suggest that low quality debt has already found
capital for corporate borrowers, namely bank loans and syndicated
THE APPEAL OF PRIVATE DIRECT LENDING
public debt. Like syndicated leveraged loans (but unlike most
In this environment, private direct lending has emerged as an
high yield bonds), these private loans feature floating interest rates, positioning investors to benefit from any rise in rates while mitigating duration risk (the likelihood that rising interest rates will push security prices down).
attractive alternative. A key demand source for this type of financing has been the middle market, a sector traditionally served by banks and too small for syndicated buyers. To provide a sense of the scale of this opportunity, it is important to point out that
Two tailwinds have been building for direct lending since 2009: (i) record low interest rates and (ii) the increasing regulation of banks. The former catalyzed a global search for yield, while the latter created a financing gap in several sectors, allowing non-bank lenders to jump in. Facing a persistent low rate environment, investors seeking to meet their historical return targets have had two options: take on more risk by moving down in credit quality to achieve higher yields, or look beyond traditional fixed income to newer strategies and trade some liquidity for high quality private credits.
the U.S. middle market generates $10+ trillion in annual revenue, accounts for a third of U.S. jobs across roughly 200,000 companies and, if measured as a country, would represent the third largest economy in the world.8 While the middle market segment is large and healthy, experiencing a 9% year-over-year increase in revenues and a 5% increase in earnings through Q1 2016, most investors have little or no exposure to this vast market.9 Private middle market loans can help investors address the fixed income conundrum, as they may carry premium yields to high yield bonds and large, syndicated leveraged loans. This yield premium is
CREDIT RISK IN THE PUBLIC MARKETS
effectively an illiquidity premium, as investors require incremental
Given the increased level of poor underwriting over the past several
Direct lenders do not compete only on price, but some can also
years, moving down the credit curve in high yield or otherwise is a high risk approach. The high yield bond default rate stood at 3.8% at the end of the first quarter, and is widely expected to accelerate.6 In addition to an increase in defaults, downgrade rating actions by S&P have increased dramatically in recent quarters, reaching a negative net 164 downgrades in the first quarter, indicating a significant drop in credit quality as perceived by S&P.7 Elevated
iCapital Network
return to compensate for the non-tradable nature of private loans. offer certainty of close and can serve as key, long-term credit providers to companies and private equity firms, effectively replacing the role that traditional banks used to play. By providing borrowers with assurance that their financing will close at the negotiated yield, which is appealing in today’s volatile markets, direct lenders can often command a premium for their loans.
441 Lexington Avenue New York, NY 10017
212 994 7400
www.icapitalnetwork.com
In addition, banks have increasingly been unwilling to underwrite
In addition to the lien priority offered by senior secured and
second lien debt at competitive rates, or even at all. By contrast,
unitranche loans, direct lenders typically insist on strong structural
direct lenders have the flexibility to provide “unitranche” financing,
protections in their credit agreements, including both maintenance
a single loan combining both a first lien tranche and a second lien,
and incurrence covenants. As “buy and hold” investors, direct
or subordinated, tranche of debt (Figure 4). Unitranche loans are
lenders perform their own due diligence on the borrowing
generally senior secured and can be viewed as providing both
company, which can often take six to eight weeks, and draft
senior collateral protection as well as junior capital economics.
their own loan agreements, in contrast to syndicated buyers who rely largely on materials provided by the borrower’s underwriter and are often “term takers” – meaning they have little ability to
FIGURE 4
negotiate terms or covenants. EQUITY Leverage: 4.0x - 8.0x LTV: 50 - 100% Market Return Range: 15% +
EQUITY
SENIOR LOAN
UNITRANCHE LOAN
SUBORDINATED LOAN
JUNIOR DEBT Leverage: 5.0x - 7.0x LTV: 50 - 70% Market Return Range: 8 - 12% + SENIOR DEBT Leverage: 2.5x - 4.5x LTV: < 50% Market Return Range: 5 - 10%
A combination of floating rate yields and the downside protection offered by capital structure seniority, thorough due diligence, covenant protection and ongoing direct monitoring of company performance, has made private direct lending an increasingly popular strategy. Investors seeking yield without compromising on credit quality, or even simple diversification from the large corporate issue market, should consider allocating to middle market direct credits as part of their overall fixed income strategy.
UNITRANCHE DEBT Leverage 5.0x - 7.0x LTV 60% - 80% Market Return Range 7 - 12% +
aroline Rasmussen is vice president at iCapital Network, C an online alternative investments platform for high-networth investors and their advisers.
Return profiles for illustrative purposes only.
iCapital Network
441 Lexington Avenue New York, NY 10017
212 994 7400
www.icapitalnetwork.com
END NOTES Preqin Press Release, May 5, 2016, Europe-Focused Direct Lending Fundraising Exceeds North America in 2015. Preqin 2016 Global Private Debt Report, May 2016. 3 Preqin 2016 Global Private Debt Report, May 2016. 4 Preqin, as of December 31, 2015; overall global buyout dry powder of $460bn, approximately 60% of which is North America focused. 5 Leveraged loan market maturities S&P LCD as of August 31, 2015. 6 Forbes, S&P Global: US High Yield Default Rate Expected to Hit 5.3% by March 2017, May 10, 2016, http://www.forbes.com/sites/spleverage/2016/05/10/sp-us-high-yield-default-rateexpected-to-hit-5-3-by-march-2017/#4ac9f7cd35d6. 7 S&P Ratings Direct. 8 National Center for the Middle Market: http://www.middlemarketcenter.org/infographics/2q2016-middle-market-indicator-infographic 9 As measured by the Golub Altman Index, which tracks median revenue and earnings growth of more than 150 privately owned companies in the Golub Capital loan portfolio. Earnings defined as EBITDA. 1
2
IMPORTANT INFORMATION / DISCLAIMER These materials are for informational purposes only and are not intended as,
information than they can access with respect to publicly listed investments.
and may not be relied on in any manner as legal, tax or investment advice, a
Prospective investors should also note that investments in the products
recommendation, or as an offer to sell, a solicitation of an offer to purchase or
described may involve long lock-ups and do not provide investors with liquidity.
a recommendation of any interest in any fund or security described herein. Any such offer or solicitation shall be made only pursuant to the final confidential offering documents which will contain information about each fund’s investment objectives and terms and conditions of an investment and may also describe certain risks and tax information related to an investment therein. This material does not take into account the particular investment objectives, restrictions or financial, legal or tax situation of any specific investor. Past performance is not indicative of future results. All of the products described are private placements that are sold only to qualified clients through transactions that are exempt from registration under the Securities Act of 1933 pursuant to Rule 506(b) of Regulation D promulgated thereunder (“Private Placements”). An investment in any product issued pursuant to a Private Placement, such as the funds described, entails a high degree of risk and no assurance can
The information contained herein is subject to change and is also incomplete. This industry information and its importance is an opinion only and should not be relied upon as the only important information available. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Securities may be offered through iCapital Securities, LLC, a registered broker dealer, member of FINRA and SIPC and subsidiary of Institutional Capital Network, Inc. These registrations and memberships in no way imply that the SEC, FINRA or SIPC have endorsed the entities, products or services discussed herein. Additional information is available upon request.
be given that any alternative investment fund’s investment objectives will be achieved or that investors will receive a return of their capital. Further, such investments are not subject to the same levels of regulatory scrutiny as publicly listed investments, and as a result, investors may have access to significantly less
iCapital Network
441 Lexington Avenue New York, NY 10017
212 994 7400
www.icapitalnetwork.com
DIRECT LENDING CONTINUES TO ATTRACT YIELD STARVED INVESTORS By Caroline Rasmussen
November 16, 2016
North American-focused private direct lending funds secured a combined $17 billion in commitments in 2015, contributing to a 144% rise in aggregate capital raised for the strategy from 2012-2015.1 The popularity of direct lending, an important component of the private debt market, looks set to continue, with 46% of investors intending to commit more money to private credit this year than in 2015, and 52% of investors planning to increase their private debt allocations in the longer term (Figures 1 and 2).2
SIGNIFICANT SUPPLY-DEMAND IMBALANCE The surge of interest in direct lending may give rise to concerns that the opportunity is becoming saturated, as investors have
FIGURE 1
INVESTORS’ EXPECTED CAPITAL COMMITMENT TO PRIVATE DEBT FUNDS IN 2016 COMPARED TO 2015
directed $51.4 billion into North American-focused direct lending funds over the past three years.3 However, the supply-demand imbalance remains significant, favoring experienced lenders. As of
MORE CAPITAL IN 2016 THAN 2015
the end of 2015, North American-focused private equity buyout
46%
firms held approximately $276 billion in dry powder.4 Assuming an average equity contribution of 40% per deal, the market is facing over $400 billion in loan demand from private equity sponsors. Combined with approximately $800 billion in looming leveraged
SAME AMOUNT OF CAPITAL IN 2016 AS IN 2015
41%
loan market maturities through 2022, the overall demand for debt financing in North America over the next five to seven years is about $1.2 trillion.5 This large financing gap does not assume any growth in the underlying corporate market, or take into account any further decreases in the proportion of senior debt capital supplied by banks, which have been retrenching from the middle
LESS CAPITAL IN 2016 THAN 2015
13%
Source: 2016 Preqin Global Private Debt Report
market due to regulatory changes.
iCapital Network
441 Lexington Avenue New York, NY 10017
212 994 7400
www.icapitalnetwork.com
FIGURE 2
FIGURE 3
COVENANT-LITE VOLUME AS A PERCENT OF TOTAL INSTITUTIONAL VOLUME
INVESTORS’ INTENTIONS FOR THEIR PRIVATE DEBT ALLOCATIONS IN THE LONGER TERM
COVENANT-LITE VOLUME AS A PERCENT OF TOTAL INSTITUTIONAL VOLUME(1)
80%
INCREASE ALLOCATION
52%
70% 60% 50% 40%
MAINTAIN ALLOCATION
DECREASE ALLOCATION
40% 8%
30% 20% 10% 0% 2010
2011
2012
2013
2014
2015
Source: S&P LCD US Interactive Volume Report
Source: 2016 Preqin Global Private Debt Report
SO WHAT EXACTLY IS DIRECT LENDING?
levels of high yield and covenant-lite issuance in recent years,
Direct lending is the provision of debt financing on a private basis
its way into many portfolios.
directly between a non-bank lender and the borrowing company. This type of lending is distinct from the traditional sources of debt
shown in Figure 3, suggest that low quality debt has already found
capital for corporate borrowers, namely bank loans and syndicated
THE APPEAL OF PRIVATE DIRECT LENDING
public debt. Like syndicated leveraged loans (but unlike most
In this environment, private direct lending has emerged as an
high yield bonds), these private loans feature floating interest rates, positioning investors to benefit from any rise in rates while mitigating duration risk (the likelihood that rising interest rates will push security prices down).
attractive alternative. A key demand source for this type of financing has been the middle market, a sector traditionally served by banks and too small for syndicated buyers. To provide a sense of the scale of this opportunity, it is important to point out that
Two tailwinds have been building for direct lending since 2009: (i) record low interest rates and (ii) the increasing regulation of banks. The former catalyzed a global search for yield, while the latter created a financing gap in several sectors, allowing non-bank lenders to jump in. Facing a persistent low rate environment, investors seeking to meet their historical return targets have had two options: take on more risk by moving down in credit quality to achieve higher yields, or look beyond traditional fixed income to newer strategies and trade some liquidity for high quality private credits.
the U.S. middle market generates $10+ trillion in annual revenue, accounts for a third of U.S. jobs across roughly 200,000 companies and, if measured as a country, would represent the third largest economy in the world.8 While the middle market segment is large and healthy, experiencing a 9% year-over-year increase in revenues and a 5% increase in earnings through Q1 2016, most investors have little or no exposure to this vast market.9 Private middle market loans can help investors address the fixed income conundrum, as they may carry premium yields to high yield bonds and large, syndicated leveraged loans. This yield premium is
CREDIT RISK IN THE PUBLIC MARKETS
effectively an illiquidity premium, as investors require incremental
Given the increased level of poor underwriting over the past several
Direct lenders do not compete only on price, but some can also
years, moving down the credit curve in high yield or otherwise is a high risk approach. The high yield bond default rate stood at 3.8% at the end of the first quarter, and is widely expected to accelerate.6 In addition to an increase in defaults, downgrade rating actions by S&P have increased dramatically in recent quarters, reaching a negative net 164 downgrades in the first quarter, indicating a significant drop in credit quality as perceived by S&P.7 Elevated
iCapital Network
return to compensate for the non-tradable nature of private loans. offer certainty of close and can serve as key, long-term credit providers to companies and private equity firms, effectively replacing the role that traditional banks used to play. By providing borrowers with assurance that their financing will close at the negotiated yield, which is appealing in today’s volatile markets, direct lenders can often command a premium for their loans.
441 Lexington Avenue New York, NY 10017
212 994 7400
www.icapitalnetwork.com
In addition, banks have increasingly been unwilling to underwrite
In addition to the lien priority offered by senior secured and
second lien debt at competitive rates, or even at all. By contrast,
unitranche loans, direct lenders typically insist on strong structural
direct lenders have the flexibility to provide “unitranche” financing,
protections in their credit agreements, including both maintenance
a single loan combining both a first lien tranche and a second lien,
and incurrence covenants. As “buy and hold” investors, direct
or subordinated, tranche of debt (Figure 4). Unitranche loans are
lenders perform their own due diligence on the borrowing
generally senior secured and can be viewed as providing both
company, which can often take six to eight weeks, and draft
senior collateral protection as well as junior capital economics.
their own loan agreements, in contrast to syndicated buyers who rely largely on materials provided by the borrower’s underwriter and are often “term takers” – meaning they have little ability to
FIGURE 4
negotiate terms or covenants. EQUITY Leverage: 4.0x - 8.0x LTV: 50 - 100% Market Return Range: 15% +
EQUITY
SENIOR LOAN
UNITRANCHE LOAN
SUBORDINATED LOAN
JUNIOR DEBT Leverage: 5.0x - 7.0x LTV: 50 - 70% Market Return Range: 8 - 12% + SENIOR DEBT Leverage: 2.5x - 4.5x LTV: < 50% Market Return Range: 5 - 10%
A combination of floating rate yields and the downside protection offered by capital structure seniority, thorough due diligence, covenant protection and ongoing direct monitoring of company performance, has made private direct lending an increasingly popular strategy. Investors seeking yield without compromising on credit quality, or even simple diversification from the large corporate issue market, should consider allocating to middle market direct credits as part of their overall fixed income strategy.
UNITRANCHE DEBT Leverage 5.0x - 7.0x LTV 60% - 80% Market Return Range 7 - 12% +
aroline Rasmussen is vice president at iCapital Network, C an online alternative investments platform for high-networth investors and their advisers.
Return profiles for illustrative purposes only.
iCapital Network
441 Lexington Avenue New York, NY 10017
212 994 7400
www.icapitalnetwork.com
END NOTES Preqin Press Release, May 5, 2016, Europe-Focused Direct Lending Fundraising Exceeds North America in 2015. Preqin 2016 Global Private Debt Report, May 2016. 3 Preqin 2016 Global Private Debt Report, May 2016. 4 Preqin, as of December 31, 2015; overall global buyout dry powder of $460bn, approximately 60% of which is North America focused. 5 Leveraged loan market maturities S&P LCD as of August 31, 2015. 6 Forbes, S&P Global: US High Yield Default Rate Expected to Hit 5.3% by March 2017, May 10, 2016, http://www.forbes.com/sites/spleverage/2016/05/10/sp-us-high-yield-default-rateexpected-to-hit-5-3-by-march-2017/#4ac9f7cd35d6. 7 S&P Ratings Direct. 8 National Center for the Middle Market: http://www.middlemarketcenter.org/infographics/2q2016-middle-market-indicator-infographic 9 As measured by the Golub Altman Index, which tracks median revenue and earnings growth of more than 150 privately owned companies in the Golub Capital loan portfolio. Earnings defined as EBITDA. 1
2
IMPORTANT INFORMATION / DISCLAIMER These materials are for informational purposes only and are not intended as,
information than they can access with respect to publicly listed investments.
and may not be relied on in any manner as legal, tax or investment advice, a
Prospective investors should also note that investments in the products
recommendation, or as an offer to sell, a solicitation of an offer to purchase or
described may involve long lock-ups and do not provide investors with liquidity.
a recommendation of any interest in any fund or security described herein. Any such offer or solicitation shall be made only pursuant to the final confidential offering documents which will contain information about each fund’s investment objectives and terms and conditions of an investment and may also describe certain risks and tax information related to an investment therein. This material does not take into account the particular investment objectives, restrictions or financial, legal or tax situation of any specific investor. Past performance is not indicative of future results. All of the products described are private placements that are sold only to qualified clients through transactions that are exempt from registration under the Securities Act of 1933 pursuant to Rule 506(b) of Regulation D promulgated thereunder (“Private Placements”). An investment in any product issued pursuant to a Private Placement, such as the funds described, entails a high degree of risk and no assurance can
The information contained herein is subject to change and is also incomplete. This industry information and its importance is an opinion only and should not be relied upon as the only important information available. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Securities may be offered through iCapital Securities, LLC, a registered broker dealer, member of FINRA and SIPC and subsidiary of Institutional Capital Network, Inc. These registrations and memberships in no way imply that the SEC, FINRA or SIPC have endorsed the entities, products or services discussed herein. Additional information is available upon request.
be given that any alternative investment fund’s investment objectives will be achieved or that investors will receive a return of their capital. Further, such investments are not subject to the same levels of regulatory scrutiny as publicly listed investments, and as a result, investors may have access to significantly less
iCapital Network
441 Lexington Avenue New York, NY 10017
212 994 7400
www.icapitalnetwork.com
