direct lending continues to 46% 41% 13% 52% 40% 8%
DIRECT LENDING CONTINUES TO ATTRACT YIELD STARVED INVESTORS 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.
SAME AMOUNT OF CAPITAL IN 2016 AS IN 2015
Combined with approximately $800 billion in looming leveraged loan market maturities through 2022, the overall demand for debt
41%
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 LESS CAPITAL IN 2016 THAN 2015
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
13%
Source: 2016 Preqin Global Private Debt Report
market due to regulatory changes.
SO WHAT EXACTLY IS DIRECT LENDING? Direct lending is the provision of debt financing on a private basis directly between a non-bank lender and the borrowing company.
FIGURE 2
INVESTORS’ INTENTIONS FOR THEIR PRIVATE DEBT ALLOCATIONS IN THE LONGER TERM
This type of lending is distinct from the traditional sources of debt capital for corporate borrowers, namely bank loans and syndicated public debt. Like syndicated leveraged loans (but unlike most high yield bonds), these private loans feature floating interest
INCREASE ALLOCATION
rates, positioning investors to benefit from any rise in rates while
52%
mitigating duration risk (the likelihood that rising interest rates will push security prices down). Two tailwinds have been building for direct lending since 2009: (i)
MAINTAIN ALLOCATION
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
DECREASE ALLOCATION
40% 8%
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.
Source: 2016 Preqin Global Private Debt Report
borrowers with assurance that their financing will close at the
CREDIT RISK IN THE PUBLIC MARKETS Given the increased level of poor underwriting over the past several years, moving down the credit curve in high yield or otherwise is a high
negotiated yield, which is appealing in today’s volatile markets, direct lenders can often command a premium for their loans.
risk approach. The high yield bond default rate stood at 3.8% at
In addition, banks have increasingly been unwilling to underwrite
the end of the first quarter, and is widely expected to accelerate.6
second lien debt at competitive rates, or even at all. By contrast,
In addition to an increase in defaults, downgrade rating actions by
direct lenders have the flexibility to provide “unitranche” financing,
S&P have increased dramatically in recent quarters, reaching a
a single loan combining both a first lien tranche and a second lien,
negative net 164 downgrades in the first quarter, indicating a
or subordinated, tranche of debt (Figure 4). Unitranche loans are
significant drop in credit quality as perceived by S&P.7 Elevated
generally senior secured and can be viewed as providing both
levels of high yield and covenant-lite issuance in recent years,
senior collateral protection as well as junior capital economics.
shown in Figure 3, suggest that low quality debt has already found its way into many portfolios.
FIGURE 4
FIGURE 3
EQUITY Leverage: 4.0x - 8.0x LTV: 50 - 100% Market Return Range: 15% +
COVENANT-LITE VOLUME AS A PERCENT OF TOTAL VOLUME COVENANT-LITE VOLUMEINSTITUTIONAL AS A PERCENT OF TOTAL INSTITUTIONAL VOLUME
(1)
EQUITY
80% 70% 60%
40%
SUBORDINATED LOAN
30% 20% 10% 0%
2010
2011
2012
2013
2014
2015
Source: S&P LCD US Interactive Volume Report
SENIOR LOAN
THE APPEAL OF PRIVATE DIRECT LENDING
UNITRANCHE LOAN
50%
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%
In this environment, private direct lending has emerged as an attractive alternative. A key demand source for this type of financing
UNITRANCHE DEBT Leverage 5.0x - 7.0x LTV 60% - 80% Market Return Range 7 - 12% +
Return profiles for illustrative purposes only.
has been the middle market, a sector traditionally served by banks and too small for syndicated buyers. To provide a sense of the
In addition to the lien priority offered by senior secured and
scale of this opportunity, it is important to point out that the U.S.
unitranche loans, direct lenders typically insist on strong structural
middle market generates $10+ trillion in annual revenue, accounts for
protections in their credit agreements, including both maintenance
a third of U.S. jobs across roughly 200,000 companies and, if
and incurrence covenants. As “buy and hold” investors, direct lenders
measured as a country, would represent the third largest economy
perform their own due diligence on the borrowing company, which
in the world.8 While the middle market segment is large and healthy,
can often take six to eight weeks, and draft their own loan
experiencing a 9% year-over-year increase in revenues and a 5%
agreements, in contrast to syndicated buyers who rely largely on
increase in earnings through Q1 2016, most investors have little or
materials provided by the borrower’s underwriter and are often
no exposure to this vast market.9
“term takers” – meaning they have little ability to negotiate terms or covenants.
Private middle market loans can help investors address the fixed income conundrum, as they may carry premium yields to high yield
A combination of floating rate yields and the downside protection
bonds and large, syndicated leveraged loans. This yield premium is
offered by capital structure seniority, thorough due diligence,
effectively an illiquidity premium, as investors require incremental
covenant protection and ongoing direct monitoring of company
return to compensate for the non-tradable nature of private loans.
performance, has made private direct lending an increasingly
Direct lenders do not compete only on price, but some can also
popular strategy. Investors seeking yield without compromising on
offer certainty of close and can serve as key, long-term credit
credit quality, or even simple diversification from the large corporate
providers to companies and private equity firms, effectively
issue market, should consider allocating to middle market direct
replacing the role that traditional banks used to play. By providing
credits as part of their overall fixed income strategy.
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/2q-2016-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
These materials are for informational purposes only and are not intended as,
return of their capital. Further, such investments are not subject to the same
and may not be relied on in any manner as legal, tax or investment advice, a
levels of regulatory scrutiny as publicly listed investments, and as a result,
recommendation, or as an offer to sell, a solicitation of an offer to purchase
investors may have access to significantly less information than they can access
or a recommendation of any interest in any fund or security described herein.
with respect to publicly listed investments. Prospective investors should also
Any such offer or solicitation shall be made only pursuant to a fund’s final
note that investments in the products described involve long lock-ups and do
confidential offering documents which will contain information about each
not provide investors with liquidity.
fund’s investment objectives and terms and conditions of an investment and may also describe certain risks and tax information related to an investment
The information contained herein is subject to change and is also incomplete.
therein. This material does not take into account the particular investment
This industry information and its importance is an opinion only and should
objectives, restrictions, or financial, legal or tax situation of any specific investor.
not be relied upon as the only important information available. Information
An investment in the fund is not suitable for all investors.
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
Past performance is not indicative of future results. Any products made available
to in any other publication, without express written permission.
to clients of iCapital, are private placements that are sold only to qualified clients of iCapital through transactions that are exempt from registration under the
Securities may be offered through iCapital Securities, LLC, a registered broker
Securities Act of 1933 pursuant to Rule 506(b) of Regulation D promulgated
dealer, member of FINRA and SIPC and subsidiary of Institutional Capital
thereunder (“Private Placements”). An investment in any product issued
Network, Inc. These registrations and memberships in no way imply that the SEC,
pursuant to a Private Placement, such as the funds described, entails a high
FINRA or SIPC have endorsed the entities, products or services discussed herein.
degree of risk and no assurance can be given that any alternative investment fund’s investment objectives will be achieved or that investors will receive a
iCapital Network
441 Lexington Avenue New York, NY 10017
Additional information is available upon request.
212 994 7400
[email protected]
www.icapitalnetwork.com
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.
SAME AMOUNT OF CAPITAL IN 2016 AS IN 2015
Combined with approximately $800 billion in looming leveraged loan market maturities through 2022, the overall demand for debt
41%
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 LESS CAPITAL IN 2016 THAN 2015
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
13%
Source: 2016 Preqin Global Private Debt Report
market due to regulatory changes.
SO WHAT EXACTLY IS DIRECT LENDING? Direct lending is the provision of debt financing on a private basis directly between a non-bank lender and the borrowing company.
FIGURE 2
INVESTORS’ INTENTIONS FOR THEIR PRIVATE DEBT ALLOCATIONS IN THE LONGER TERM
This type of lending is distinct from the traditional sources of debt capital for corporate borrowers, namely bank loans and syndicated public debt. Like syndicated leveraged loans (but unlike most high yield bonds), these private loans feature floating interest
INCREASE ALLOCATION
rates, positioning investors to benefit from any rise in rates while
52%
mitigating duration risk (the likelihood that rising interest rates will push security prices down). Two tailwinds have been building for direct lending since 2009: (i)
MAINTAIN ALLOCATION
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
DECREASE ALLOCATION
40% 8%
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.
Source: 2016 Preqin Global Private Debt Report
borrowers with assurance that their financing will close at the
CREDIT RISK IN THE PUBLIC MARKETS Given the increased level of poor underwriting over the past several years, moving down the credit curve in high yield or otherwise is a high
negotiated yield, which is appealing in today’s volatile markets, direct lenders can often command a premium for their loans.
risk approach. The high yield bond default rate stood at 3.8% at
In addition, banks have increasingly been unwilling to underwrite
the end of the first quarter, and is widely expected to accelerate.6
second lien debt at competitive rates, or even at all. By contrast,
In addition to an increase in defaults, downgrade rating actions by
direct lenders have the flexibility to provide “unitranche” financing,
S&P have increased dramatically in recent quarters, reaching a
a single loan combining both a first lien tranche and a second lien,
negative net 164 downgrades in the first quarter, indicating a
or subordinated, tranche of debt (Figure 4). Unitranche loans are
significant drop in credit quality as perceived by S&P.7 Elevated
generally senior secured and can be viewed as providing both
levels of high yield and covenant-lite issuance in recent years,
senior collateral protection as well as junior capital economics.
shown in Figure 3, suggest that low quality debt has already found its way into many portfolios.
FIGURE 4
FIGURE 3
EQUITY Leverage: 4.0x - 8.0x LTV: 50 - 100% Market Return Range: 15% +
COVENANT-LITE VOLUME AS A PERCENT OF TOTAL VOLUME COVENANT-LITE VOLUMEINSTITUTIONAL AS A PERCENT OF TOTAL INSTITUTIONAL VOLUME
(1)
EQUITY
80% 70% 60%
40%
SUBORDINATED LOAN
30% 20% 10% 0%
2010
2011
2012
2013
2014
2015
Source: S&P LCD US Interactive Volume Report
SENIOR LOAN
THE APPEAL OF PRIVATE DIRECT LENDING
UNITRANCHE LOAN
50%
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%
In this environment, private direct lending has emerged as an attractive alternative. A key demand source for this type of financing
UNITRANCHE DEBT Leverage 5.0x - 7.0x LTV 60% - 80% Market Return Range 7 - 12% +
Return profiles for illustrative purposes only.
has been the middle market, a sector traditionally served by banks and too small for syndicated buyers. To provide a sense of the
In addition to the lien priority offered by senior secured and
scale of this opportunity, it is important to point out that the U.S.
unitranche loans, direct lenders typically insist on strong structural
middle market generates $10+ trillion in annual revenue, accounts for
protections in their credit agreements, including both maintenance
a third of U.S. jobs across roughly 200,000 companies and, if
and incurrence covenants. As “buy and hold” investors, direct lenders
measured as a country, would represent the third largest economy
perform their own due diligence on the borrowing company, which
in the world.8 While the middle market segment is large and healthy,
can often take six to eight weeks, and draft their own loan
experiencing a 9% year-over-year increase in revenues and a 5%
agreements, in contrast to syndicated buyers who rely largely on
increase in earnings through Q1 2016, most investors have little or
materials provided by the borrower’s underwriter and are often
no exposure to this vast market.9
“term takers” – meaning they have little ability to negotiate terms or covenants.
Private middle market loans can help investors address the fixed income conundrum, as they may carry premium yields to high yield
A combination of floating rate yields and the downside protection
bonds and large, syndicated leveraged loans. This yield premium is
offered by capital structure seniority, thorough due diligence,
effectively an illiquidity premium, as investors require incremental
covenant protection and ongoing direct monitoring of company
return to compensate for the non-tradable nature of private loans.
performance, has made private direct lending an increasingly
Direct lenders do not compete only on price, but some can also
popular strategy. Investors seeking yield without compromising on
offer certainty of close and can serve as key, long-term credit
credit quality, or even simple diversification from the large corporate
providers to companies and private equity firms, effectively
issue market, should consider allocating to middle market direct
replacing the role that traditional banks used to play. By providing
credits as part of their overall fixed income strategy.
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/2q-2016-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
These materials are for informational purposes only and are not intended as,
return of their capital. Further, such investments are not subject to the same
and may not be relied on in any manner as legal, tax or investment advice, a
levels of regulatory scrutiny as publicly listed investments, and as a result,
recommendation, or as an offer to sell, a solicitation of an offer to purchase
investors may have access to significantly less information than they can access
or a recommendation of any interest in any fund or security described herein.
with respect to publicly listed investments. Prospective investors should also
Any such offer or solicitation shall be made only pursuant to a fund’s final
note that investments in the products described involve long lock-ups and do
confidential offering documents which will contain information about each
not provide investors with liquidity.
fund’s investment objectives and terms and conditions of an investment and may also describe certain risks and tax information related to an investment
The information contained herein is subject to change and is also incomplete.
therein. This material does not take into account the particular investment
This industry information and its importance is an opinion only and should
objectives, restrictions, or financial, legal or tax situation of any specific investor.
not be relied upon as the only important information available. Information
An investment in the fund is not suitable for all investors.
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
Past performance is not indicative of future results. Any products made available
to in any other publication, without express written permission.
to clients of iCapital, are private placements that are sold only to qualified clients of iCapital through transactions that are exempt from registration under the
Securities may be offered through iCapital Securities, LLC, a registered broker
Securities Act of 1933 pursuant to Rule 506(b) of Regulation D promulgated
dealer, member of FINRA and SIPC and subsidiary of Institutional Capital
thereunder (“Private Placements”). An investment in any product issued
Network, Inc. These registrations and memberships in no way imply that the SEC,
pursuant to a Private Placement, such as the funds described, entails a high
FINRA or SIPC have endorsed the entities, products or services discussed herein.
degree of risk and no assurance can be given that any alternative investment fund’s investment objectives will be achieved or that investors will receive a
iCapital Network
441 Lexington Avenue New York, NY 10017
Additional information is available upon request.
212 994 7400
[email protected]
www.icapitalnetwork.com
