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Friday letter: The illiquidity premium – or lack thereof

Today’s leveraged finance market – particularly syndicated loans for larger mid-market companies – doesn’t offer enough of a risk premium for fund investors locking up cash for more than five years.

In both Europe and the US, many private debt providers are making more noise about price compression in the leveraged finance market. Falling margins are influenced by a number of factors, not least competition for assets among various lenders as continuing historically low central bank rates push investors to seek yield. A report produced by the Loan Secondary Trading Association in April last year showed that average yields from leveraged loans to both mid-market and large corporates have trended lower for more than two years. Mid-market loan yields fell from above eight percent in mid-2011 to under six percent in the first quarter of 2014.

Keeping pace with where the market is pricing debt is important in the battle for market share but private debt providers have to ask themselves – are they still getting paid for the risks they take?

Loan markets aren’t particularly liquid in that you can only trade out of a credit as long as all is well with it. For the time being, this may not seem to matter much. With interest rates still at historic lows across most developed markets, even the most highly levered credits have been managing to stay on top of their debt obligations.

However, lenders are typically in it for at least the medium term. With money out to work for five years or more, and interest rates bound to start rising eventually, no-one can say with confidence that the current favourable credit conditions will last the term of their vehicle. There’s only one sure conclusion: when the music stops, sellers wanting to get out of a deal will have to take a hit below par.

This is the key risk that no debt provider should ever lose sight off. The trouble is that they do, especially when markets are as frothy as they are today.

A recent report on the outlook for private credit in 2015 by White Oak Global Advisors put it well: “Lastly, there will always be banks, bankers, direct lending managers and all other types of investors that “get it wrong” and do not price risk appropriately in any market condition (deflation, stagflation or even inflation). Just because a manager is unable to price risk appropriately because they are fishing in an overcrowded pond does not mean that it is the only pond out there.”

Debt funds are not banks. Their managers should be motivated by getting the best possible returns, not by doing the largest number of deals and collecting as much as possible in fees.

Banks are terrible at saying no to low pricing – look under the hood of any competitive syndicated loan deal and you will find bank lenders in a race to the bottom while they tell journalists that this or that bank is the ‘low-ball’ institution.

Private lenders, on the other hand, can say no to a deal that fails to reward the risks. Managers must demand an illiquidity premium, and if they can’t find it in the syndicated loan market, then they should move on to another source of deals.

According to White Oak, it’s in private equity sponsored transactions where illiquidity risk is particularly badly under-priced. Their recommendation is for lenders to look for business in the non-sponsored segment, which is a much larger market to start with, less competitive and increasingly receptive to alternative forms of financing, especially those that come with greater flexibility than conventional bank loans.