Where do you feel managers are best able to drive returns in a borrower-friendly environment?
It depends where you play in the market. There is competition in the mid to lower middle market, where NXT is most active, but the overall risk adjusted returns remain quite compelling. In our core market, senior debt transactions typically price in a range of LIBOR plus 425 to 500 basis points. This represents a modest decline from levels seen in 2017, but total yield has increased as LIBOR has bumped up over the past 12 months.
Towards the upper end of the mid-market, and certainly in the broadly syndicated market, attractive returns are getting more difficult to generate because there is cutthroat competition for deals.
Overall, we are seeing some of the best opportunities come from supporting the growth of existing borrowers. As an incumbent lender, we are well positioned to lead new transactions in a change of control situation, and benefit from a steady flow of incremental financings such as add-on acquisitions. With roughly 170 borrowers already on our books, many with sponsors with whom we’ve had relationships for decades, we can consistently deploy capital while having the luxury of stepping back from transactions when pricing or terms are too aggressive for our liking. Especially in today’s market, there is a significant advantage to having a large existing portfolio to generate follow-on financing opportunities.
How important is fund-level leverage in the context of a mid-market lending strategy?
At NXT, it is driven by investor demand. Over the last several years NXT has raised multiple funds and separately managed accounts that provide investors with access to middle market loans we originate and manage. To satisfy investor preference, some of these vehicles are structured to employ leverage while others remain unlevered. The use of leverage can offer investors the opportunity to earn a higher return at the fund level without having to take more risk on a deal by deal basis, while unlevered funds are attractive to investors who are perhaps less return sensitive and prefer a more conservative approach.
To what extent does fund-level leverage enhance returns and how have these financing alternatives evolved?
Some managers drive fund returns through the nominal yield on loans they finance which can require them to offer loans with higher leverage or to finance companies with weaker and more cyclical credit fundamentals. By contrast, NXT is an advocate of achieving similar high single-digit returns by building a diversified portfolio of more conservatively structured loans and levering this moderately at the fund level.
“The use of leverage can offer investors the opportunity to earn a higher return at the fund level without having to take more risk on a deal by deal basis, while unlevered funds are attractive to investors who are perhaps less return sensitive and prefer a more conservative approach”
In terms of the types of financing available to funds, they are commonly loans secured by the underlying portfolio, frequently referred to as asset backed financing. Overall, two structures are most prevalent. They both share many common features, including matching the loan term to the life of the funds themselves, but the biggest difference is whether the lender, most commonly a bank, will have approval rights with respect to the loans to be financed. These approval rights structures generally provide more flexibility, but do require close alignment in terms of risk appetite between the manager and the bank. Alternatively, there are financing structures without loan level approval rights, but in exchange have many of the same types of tests and limits found in CLOs. The latter can be administratively more time intensive or potentially create constraints in optimising financing. The former is most prevalent and has been championed by several of the largest banks in this market, but both are very viable options, and arguably should provide investors added comfort around portfolio construction.
There has been a significant influx in capital from banks and others into this space that helps managers like us obtain portfolio leverage against the pools of loans that we manage. We have seen many banks and insurance companies enter this market, particularly to support established managers, and along the way they have discovered this to be a compelling way to invest in middle market loans on an indirect basis. We have seen the market evolve from four or five lenders a few years back providing portfolio leverage against middle market portfolios to over 25 today.
There has been quite a bit written about the expanded use of subscription lines in the private equity world to enhance returns and manager fees. We see these less frequently in loan funds, and while many have expressed interest in providing us subscription lines; we have not used these in our vehicles as our investors to this point have consistently shown the ability and desire to invest capital as soon as possible.
How do you mitigate risks associated with fund-level leverage and ensure transparency?
In our experience, investors generally find fund-level portfolio leverage acceptable at 1.5x to 2x of the invested equity capital. Beyond that, investors express concern about introducing too much risk. Accordingly, our funds are managed to these levels.
We further mitigate the risk of using leverage by not seeking maximum asset level advance rates and maintaining a well-diversified portfolio. As a result, performance issues with a particular loan that result in a reduction in the advance rate are unlikely to impact overall fund liquidity. Even if this were to occur across several exposures, the structure allows us to manage liquidity prudently and avoid the risk that the credit facility goes into default. If a portfolio is more concentrated, comprising fewer transactions with higher loan balances, leverage can be more problematic if there are performance issues with any one loan. It is equally important to focus on more conservatively structured first lien transactions, to avoid doubling down on risk by having either fully levered unitranche or stretch senior transactions coupled with portfolio leverage. In our experience, this combination adds a level of risk that concerns investors
In a competitive market, how do you think deal sourcing strategies among managers have changed?
I think it has become more important than ever to establish and maintain close relationships with private equity sponsors to enable direct transaction sourcing. As NXT, and a handful of other top-tier lead arrangers have raised substantial amounts of third-party capital they can deploy, hold sizes have increased significantly, and transactions are often spoken for by a single lender or a small club, often arranged by sponsors themselves.
The days when it was possible to build and operate a business as a buy-side participant are largely a thing of the past, especially when you are in the sub $200 million transaction size. Accordingly, we continue to focus on putting more feet on the street to work with more sponsors and drive additional transaction flow to the platform. However, it’s not just about seeing the deals, sponsors are also looking for professionals who are exceptionally responsive and provide highly specific feedback on transactions.
Furthermore, in the intensely competitive deal environment that sponsors operate in today, they need a lending partner who can provide speed and certainty of close. It’s very important to rally the organisation around new opportunities that we have conviction about or competitors will quickly displace us. This is something we focus on every day.