Worth about a third of total US gross national product, if the American mid-market were a country it would be the world's fifth-largest economy. So, as banks' lending patterns have changed and firms turn to private lenders, it's little wonder that returns from loans to companies with EBITDA of $10 million-$75 million have caught the eye of investors from further afield.
Facing low interest rates, political uncertainty and tepid economic recovery at home, mid-market focused US debt funds have proved particularly attractive to LPs from Europe and Asia. Quantifying the levels of such interest is not straightforward, but anecdotal reports from US managers and consultants suggest that there has been a surge of interest among international investors in the last 12 to 18 months. Such cross-border interest reflects, in part, a natural progression in the ongoing evolution of the asset class. However, some in the market caution that while these recent returns have been attractive, investors may not fully appreciate how their strategies will fare after the inevitable turn in the credit cycle.
One reason why overseas investors are interested in the US private debt market is that it is more developed than its counterparts in Europe and Asia. Foreign LPs are attracted by the track records and perceived security of investing with some of the industry's bigger names, which can offer a deeper roster of more highly developed strategies.
Sanjay Mistry, of Mercer Private Markets, says that the interest in US private debt funds has sprung from the early success some of his firm's global clients have seen in their local private debt markets. Risk appetite and the corresponding receptiveness to the use of leverage separates the approaches of LPs from various regions to the US market, according to Mistry – Asian investors are often more comfortable with a higher degree of risk, while European investors generally take a more conservative approach.
Many in the market report that differing risk appetite plays an important role in the willingness to search outside one's own borders when looking for opportunities in private debt.
According to Ted Koenig, of Monroe Capital, overseas investors into US mid-market private debt funds often look for exposure to a diversified swathe of the market as part of an effort to replace the yield they are used to getting from other sources. There are varying degrees of understanding, however, regarding the level of risk that comes from different sectors of the market or lending approaches involving multiple parts of the capital stack.
“All middle-market lenders are not equal,” he says. “The investors need to understand the quality of return that they are seeking.”
Some recent foreign investors fail to understand the structural difference in recovery rates between first and second lien debt, according to Golub Capital chief executive Lawrence Golub. While some LPs may assume that investments lower in the capital stack of the US mid-market are safe, they may be drawing more security than is warranted at this stage in the cycle.
“Some people are confusing what it means to be second lien as just a little bit riskier than first lien, as opposed to what it is, which is really subordinated debt,” he tells PDI. “We are observing a loss of discipline, or a loss of understanding, of what the potential loss in a financial distress situation is by some of the new money that is moving into second lien.”
The potential for confusion is not confined to the distinctions between senior and junior debt.
Robert Radway, of NXT Capital, says there is an opportunity for international investors getting into the US private debt markets to learn more about the differences between strategies employed within senior debt itself. While foreign investors generally understand that senior debt is less risky than subordinated debt, Radway says not all grasp the nuances that distinguish straight senior debt, unitranche transactions and 'first out, last out' structures, for example.
“The international investor … broad-brushes the senior debt category in a way that ultimately needs to change,” he says. “As the difference in performance from the various product types plays out, clearly there is more risk the more yield you are generating, and I'm not sure that is fully understood.”
Others respond that what some in the market may see as a lack of understanding on the part of foreign investors might actually reflect a difference in opinion regarding the macroeconomic factors that will help determine the success or failure of any investment in the current environment.
Hans-Jorg Baumann, chairman and senior partner at Swiss Capital, says that while he and his firm agree with the widely-held opinion that the market has entered the later stages of the credit cycle and an increase in defaults is inevitable, they do not foresee that uptick occurring over the next year. That position, he suggests, may account for some of the chatter that he and his European colleagues are underestimating the risk of subordinated debt strategies in the US mid-market in the current environment.
“Some people may say, 'Oh, you know, they don't understand the risks they're taking.' Such comments are generally from market participants that are rather convinced that defaults will pick up in the next 12 months,” he tells PDI.
“Other market participants have a different view or are more focused on marketing and fundraising and say that in the next four years nothing is happening because the refinancing markets are healthy, no maturity wall is looming and the economy is doing well.
“We believe everyone has to take their own stance and implement their own view on macroeconomics in portfolio construction.”
The search for yield that serves as the main driver for all growth in private debt is a global phenomenon. With little sign of significant change in the monetary or economic backdrop on the horizon, there is reason to expect that foreign interest in US private debt funds will continue to grow. Given that the increasing diversity of strategies on offer seems to cause confusion among even some long-time market observers, it is no surprise that foreign investors into the market face a learning curve.
While the growing interest in the US mid-market is a positive signal for fund managers and consultants, if and when conditions in the wider credit market take the long-expected turn for the worse, the consequences are hard to predict. In the meantime, these investors are well advised to do their best to stay close to developments in a rapidly-changing strategic landscape.
“It's like any investment,” Radway says. “You have to do your homework.” ?
According to Daniel Meehan, a tax partner at law firm Kirkland & Ellis in Chicago, non-US investors have two principal tax concerns when investing in US private debt funds: filing requirements and US tax withholding.
Meehan says non-US investors into private debt funds are often most concerned with ensuring that they are not subject to US tax filing obligations, which would arise if the fund is deemed to be engaged in a US trade or business. Such filing requirements are particularly an issue for debt funds that originate their own senior loans on a regular basis. For such funds, various structures can be used to address the tax filing concern, including use of a separate fund vehicle for non-US investors that does not engage in origination activity.
There is a 30 percent withholding tax on US source interest income paid or allocated to non-US investors, but income tax treaties can reduce that withholding tax for some foreign investors; down to zero for investors from certain countries and 10-15 percent for others.
Such treaties are negotiated by the US government on a country-by-country basis. However, even investors from countries that may not have such treaties can utilise the portfolio interest exemption, which imposes specific requirements on the process by which debt is transferred.
Meehan says non-US investors should ensure that managers of the funds in which they are investing are aware of these rules and have put in place the necessary procedures to benefit from the portfolio interest exemption.