Private Credit
We use a graphic1 from the May 31, 2016 Wall Street Journal in some of our presentations to bring home the challenges of today’s low interest rate environment. The data is a few years old, but the conundrum still holds – matching the return that used to be available with a simple bond portfolio probably requires a substantial risk increase. And the introduction of this equity risk raises the uncertainty of that return versus the good old days of buying a few bonds and hitting the golf course by noon (at least that’s what 1995 looks like in the graphic, some of us remember it differently).
The graphic presumes only the public credit markets are available to investors. For certain qualified investors, though, their playbook is more robust. Specifically, they may have the chance to earn a premium for lending in the private markets to entities that aren’t large or cookie-cutter enough to access the cheaper public markets. In the case of the WSJ’s contemplated problem, we believe this activity is part of the solution. Helpfully, it doesn’t require investors to dip into the bottom of the capital structure. Additionally, most loan compensation is floating rate which potentially allows for investors to earn more if interest rates increase. We present our case for private lending in the comments to follow.
The Opportunity Set
There are two large areas of demand for private loans that, with the right originator, borrower, and collateral, we find attractive. The first is lending to private companies with a record of profitability but a size shy of the minimum to access the syndicated bank loan or high yield bond markets. These are companies with less than $100 million in earnings before interest, tax, depreciation, and amortization (EBITDA) and usually owned by private equity groups. A manager in this category will typically agree to lend up to a certain multiple of EBITDA (these managers are sometimes called cash flow lenders). That threshold is around 4x for senior lenders today. The businesses that secure 4x EBITDA financing are usually worth 8x or more, therefore the loan-to-value (LTV) ratios are generally 50% or lower.
The security for the loan derives from the senior claim on the assets of the company. In the case of a 50% LTV loan, the recoverable business value would have to fall by 50% or more before your principal becomes impaired. The remoteness of this risk combined with the diversification of many loans to different types of companies should support the stability of portfolio-level principal in most market environments. Typically, the loan is outstanding for three to five years and has a bullet maturity, in which the full amount is due at the end of the term.
The real estate market also demands private capital. Banks provide loans for the most stable buildings at very low rates. However, many are a level below banks’ underwriting standards – they may require a lease-up plan or some transitional work – and pay higher rates elsewhere to access debt capital. The private capital provider’s underwriting is based on the value of the building; lenders endeavor to not exceed a certain LTV threshold. In major metropolitan areas, that threshold is around 70% for the type of financing we track. Loans in this market are also shorter term in nature, usually not more than five years, and typically require a bullet repayment of principal at maturity.
There are niche areas of the private lending market that are interesting as well. For example, we’ve spent a lot of time with groups that purchase commercial airplanes – Boeing and Airbus jets – and lease them to operators. While technically not a lending activity, it has the same feel: consistent interest in the form of rental income and the chance to collect principal by selling off the plane if trouble arises. We’re attracted to managers focused on planes in their second decade of life that carry shorter leases, allowing for rapid amortization and more accurate maintenance and residual value forecasts.
Comparison to Public Markets
When evaluating any private investment, we are careful to consider if the public markets effectively provide the same opportunities with the added benefit of liquidity. There is a direct comparison to make here between the corporate cash flow lenders and publicly trade syndicated bank loans, nearly a $1 trillion market available to most investors through ETFs and mutual funds. The industry standard for measuring this market is the S&P/LSTA Leveraged Loan Index. Per Eaton Vance’s Floating Rate Loan Chart Book, as of year-end 2017, the average index coupon was LIBOR plus a spread of 3.4% for a total of 5.1%. The default rate, excluding recoveries, over the last 12 months was 2%.
One potential disadvantage of moving to the private market is the loss of liquidity. This matters, but we think there are mitigants. First, the liquidity of the publicly traded loans famously dries up in times of stress anyway, so the loss of liquidity isn’t all that it seems. The buy and hold-to-maturity approach in the private markets is perhaps the better approach.
There are economic advantages to the private side that mitigate as well. Yields can be a few points higher to compensate for that loss of liquidity. Most loans come with upfront origination fees and may issue at a discount (e.g. lending $9.8 million and requiring $10 million back at maturity). And whereas companies accessing the syndicated loan market are increasingly able to negotiate away covenant protections (accounting tests that the company must meet periodically and restrictions on what the company can spend money on), private managers have generally done a better job maintaining these terms in the deal documents. This gives the lender much better control of deteriorating situations, improving the likelihood and magnitude of recovery should the borrower default.
Private real estate lenders, in exchange for a loss of liquidity, earn a premium over the commercial mortgage backed securities (CMBS) component of the Barclays Aggregate Bond Index. As of year-end its yield was only 3.3%; at such anemic levels the private market can currently provide double the rate of return.
Portfolio Construction
We believe there are attractive opportunities within private credit for qualified clients willing to accept some illiquidity. Keel Point is bringing to market a fund that provides an easy way to access a portfolio of five to seven compelling credit strategies. In the process of arriving here, we have reviewed over fifty offerings. Managers were selected based on a number of factors but demonstrated underwriting success and prudent use of leverage were primary considerations.
In segments like US corporate lending, we are most comfortable with managers with a track record through the financial crisis and loss rates better than what we saw for the Leveraged Loan Index. Corporate lending in Europe is newer to the private space (previously banks effectively owned that market), but the business is growing and it now offers a valuable source of diversification. On the real estate side, we are most comfortable with groups lending in major metro areas in four major market segments – office, multi-family, industrial, and retail (with allocation constraints on retail). In all cases, we looked for a commitment to almost always be the senior or most secured lender.
Most managers use leverage to enhance returns. Of course, it can also magnify losses. From our team’s various seats during the financial crisis, we observed how using shorter-term leverage to finance longer-term assets worked to unravel otherwise sound investment strategies. Therefore, we sought out groups who have worked to match financing facilities with loan maturities in an effort to keep themselves in control of their assets and reduce the risk of a margin call induced fire-sale at the worst possible time.
We plan to allocate capital to managers in a way that increases diversification and provides credit exposure that reflects our “late cycle” market view. The fund’s portfolio will be diversified by number of loans or loan equivalents (hundreds), by region (US and Europe), and by borrower (corporate, real estate, airline, etc). The majority of loans will be floating rate that produce higher returns in a rising rate environment. We chose to restrict the corporate loan exposure in the fund to half or less, with some of that slice going to European companies. This reflects our view that this is the most popular space, especially in the US, with the most dollars competing for loans. We also believe integrating niche opportunities, such as aircraft leasing, offers meaningful diversification. As equity markets become more volatile and investors worry about rising interest rates, the annual income and stability of returns generated by diversified private credit exposure may be additive to portfolios seeking expected returns without taking excessive equity market risk.□
This material is distributed for informational purposes only.
The investment ideas and expressions of opinion may contain certain forward-looking statements and should not be viewed as recommendations, personal investment advice or considered an offer to buy or sell specific securities. Data and statistics contained in this re-port are obtained from what we believe to be reliable sources including Eaton Vance and The Wall Street Journal, but their accuracy, completeness or reliability cannot be guaranteed. An index is an unmanaged weighted basket of securities generally representative of a certain market or asset class. An investment cannot be made directly in an index. Our statements and opinions are subject to change without notice and should be considered only as part of a diversified portfolio. No conclusion should be drawn from any chart, graph or table that such illustration can, in and of itself, predict future outcomes. You may request a free copy of Keel Point’s Form ADV Part 2, which describes, among other items, risk factors, strategies, affiliations, services offered and fees charged.
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