Banks scaled back their lending operations, creating a financing gap that non-traditional lenders and private funds rushed to fill. This piqued the interest of institutional investors, who continue to search for yield in a low interest rate environment. That same environment prompted many private companies to refinance through the high yield and leveraged loan markets, which in turn led retail investors to dedicate record amounts of capital to those strategies. Through it all, new players of different sizes, structures and strategic approach began to engage the market, challenging conceptions of who is best suited to fill the financing gap.
All of the above is apparent if you’ve observed the US private debt market over the last few years. But it doesn’t leave much room for nuance and, as the expression goes, the devil lies in the details.
Private Debt Investor hosted its first US roundtable in November, drawing on the perspectives of five private debt industry veterans to explore how investors, managers and companies view the private debt market today. As the participants convened in a conference room in CIFC Asset Management’s midtown Manhattan office, it quickly became apparent that although the opportunities for investors remain, finding the best way to access those opportunities is still a challenge.
One thing is certain, however: the ebbs and flows of the banking sector continue to dictate how firms can put their capital to work.
“That’s the nature of our business, trying to assess the hundreds of billions of dollars that are on banks’ balance sheets,” says Ivan Zinn of Atalaya Capital Management. “It’s still an abnormally high level to where it would have been pre-’08, so it’s less than it was at the peak – around half a trillion. Now it’s around $300 to $400 billion, depending on how you do that math.”
Zinn’s firm specialises in the acquisition of mid-market and lower mid-market assets from banks, a practice that was (until recently) unique to the US.
“European banks don’t sell,” Zinn says, prompting chuckles from the other participants. “I ran around Europe a few years ago when everyone thought Basel II would present opportunity. And there wasn’t a lot to do there then, and I do think now it’s different. Obviously, we don’t traffic in Europe on a frequent basis right now, but I do think now is different. For a large firm like GSO and others, they have nice flags there ready to buy things. And occasionally they’ll get nice trades. But the nature of the US banking system is that it has been one that sells loans.”
That sell-off hasn’t trickled down to the community bank level, however, where Chris Acito of Gapstow believes many institutions are re-entering the market after a lengthy fallow period: “Many smaller banks are beginning to re-build their loan portfolios. Holding common equity positions provides exposure to small business loans, sometimes priced below book value.”
“Do you think that community banks are a good business?” Zinn asks. “I’ve sat on boards of small banks. That business is just worse than it used to be. You can’t make the ROE, the cost of the regulatory burden is really high. I’d argue it’s a much worse business in general.”
“In aggregate, yes,” Acito says. “But the business isn’t going away. Lending is ticking up a little bit. In the community banking sector, there are clearly emerging haves, not-so-haves and have-nots.”
“I wouldn’t say it’s a case of, ‘Go out and buy the index’, but there is a cadre of banks right now whose biggest strategic issue is plugging holes in their balance sheets. They can’t raise capital quickly enough to support all the loan growth that’s in front of them,” Acito adds.
That has been true at the higher end of the market as well, argues Lou Salvatore of GSO Capital Partners. Although banks are not seeking to acquire risky assets – thanks largely to a stricter regulatory regime – they are still extremely active. They can’t resist the combination of readily available financing capital and strong demand from borrowers.
“I think in today’s world, where there’s a ton of liquidity and there’s a search for yield where all the different pockets of credit are taking in money, banks are emboldened. They’re not in the business of owning risk but to the extent that they can set up deals and syndicate those, they’ll do that all day long. And with the markets the way they are, I think banks are fairly emboldened to bring deals and they’re able to get them done,” he says.
That confidence isn’t reserved for situations that call for an agent. According to Salvatore, the banks still feel relatively confident putting their balance sheet to work as well.
“They’ll commit to deals because they have a lot of confidence that they can syndicate them. I think when they lose that confidence they’ll pull back quicker. They’re not in the business of owning anything on balance sheet. But they’re aggressive with their commitments today because they haven’t had many problems in the way of selling paper.”
The banks’ willingness to put capital to work at the larger end of the market has certainly created opportunities for firms to invest through syndications, however, it’s unclear whether the illiquidity risk the firms must undertake for access is being priced appropriately, says Oliver Wriedt, who heads CIFC’s capital markets and distributions segment.
“As we look at the syndicated market and the club market where either a bank or finance company works as agent, we find that we’re not getting paid particularly well for illiquidity, particularly at this stage in the credit cycle, given the bid that’s out there for senior secured US bank loans,” Wriedt says, adding that his firm has found a “sweet spot” investing in sub-$1 billion enterprise value companies that support $300 to $500 million of senior secured bank debt. CIFC finds it to be a market segment that is generally overlooked by large mutual fund complexes.
Accessing those deals may be problematic however, particularly at the pricing offered by the syndicates.
“Oftentimes they require sort of an invitation from the sponsor to get involved, particularly in the more interesting transactions. That’s where we found better relative value vis-à-vis the syndicated mid-market, where the increment might be 100 basis points. We don’t think that that really justifies the illiquidity associated with that instrument in anything but today’s market,” he says.
“So if 100’s the wrong premium to get paid for the illiquidity, what’s the right premium?” Zinn asks the group. “If 100’s not right, is it 500? Something in between, where the grey area starts show up?”
It’s a very good question – one that leads to plenty of back-and-forth amongst the panelists. To Gapstow’s Chris Acito, it is the “the number one question investors are asking right now”, particularly given the amount of money that has been raised through more liquid credit instruments.
“Private credit has become hot and people are interested in it. But, relative to the more liquid opportunities, you have to be honest and ask, ‘What is the extra bump in return?’ Also, is it really worth fighting that wall of capital raised to invest in certain illiquid strategies? It’s probably the number one debate we’re having at our firm.”
Wriedt compares the current environment to the one that existed in the years leading up to the global financial crisis.
“If we go back to 2006-2007, we saw a very similar compression in the basis between broadly syndicated loans and those distributed in the clubbed or lightly-syndicated mid-market. In that era, we saw a lot of these things built specifically for CLOs. Because you couldn’t make the CLO arbitrage work, you needed to buy these loans to drive your arb. For most managers that didn’t end well.
“Now from a price perspective, those loans didn’t drop as much as much as the large syndicated loans back in 2008. But obviously, the credit experience was different – it was worse. It was clearly worse. So from that perspective, we’re wary of this basis. In ’06-’07, those deals were more aggressively levered than today. Spreads in the absolute were lower. So in that respect we’re not where we ended up in late ’07 but we think there needs to be more of a premium. So where I think it gets to be interesting is in that 200-250 basis point pick-up for a solid $25-$35 million EBITDA business with good structure.”
Deal availability, and thus pricing, improves as you move down market, according to Harbert Mezzanine Partners’ senior managing director John Harris. Unlike GSO and CIFC, which specialise in what some may label the upper mid-market, Harrison’s firm typically provides $3 million to $15 million in mezzanine financing to companies with enterprise values that fall below $100 million, a space that puts them well within the confines of the lower mid-market.
“The good thing about our market is, pre-recession we saw a lot of CLOs buying small company private debt. We saw the national footprint finance companies in our market and a lot of hedge funds were lending directly to pretty small businesses. Pretty much all of that has gone away. Pre-recession, I had a CLO manager tell me, ‘I can do it a lot cheaper than you can because I can just leverage more’,” Harrison says. “Yeah, well that didn’t work out real well.”