The modern maxim that one should go to the dentist every six months puts dread in the hearts of the timorous, but is music to the ears of Robert Radway, Chicago-based chairman and CEO of NXT Capital.
These businesses offer strong “recurring patterns” of spending, he says, with a “very steady flow of demand that’s defensive” – insensitive to the economic cycle. After all, “you go to the dentist every year or twice a year”. These are “the type of companies that support higher leverage”.
It’s these reliable, perhaps slightly dull, characteristics that appeal to firms such as Radway’s which specialise in senior debt.
“As a lender we like ‘boring’,” says Mike McGonigle, New York-based managing director of Audax Senior Debt, a division of Audax Group, which invests in mid-market US companies. “We look for very ‘Steady Eddie’ companies, which make something that’s been around through economic cycles, and which has shown levels of financial performance that show they are able to pay us back.”
The desire among senior debt lenders for highly reliable companies is understandable given the limited returns available. Senior debt holders are generally not given equity, unlike many lenders further down the capital structure, and the debt coupons are unspectacular.
Audax sees average yields in the US market of 4.5-5.5 percentage points above Libor; for the BNP Paribas European SME Debt Fund, which closed in October with €500 million in capital, the planned yield is Libor plus 3.5 percentage points, according to Laurent Gueunier, Paris-based head of alternative debt management at BNP Paribas Investment Partners.
Some investors prefer higher returns, through funds that lend lower down the capital structure through second-lien or mezzanine loans, or through private equity – but Gueunier takes a sober-minded view of such ventures. “Excitement comes with a cost: a heavy capital charge for some investors, and volatility for everybody,” he says.
For the sort of senior debt that his new fund finances – borrowed by companies sourced by BNP Paribas’ banking network, to which the banking part of the group must also commit to lend – “this is not the case: it’s not volatile”. The bulk of the fund’s loans are likely to be to French businesses.
Senior debt lenders argue their products are attractive to investors precisely because of the lack of excitement.
Radway, whose firm specialises in senior debt lending to mid-market US companies, says: “We think that, at least in the US, senior debt offers the best risk-adjusted returns when you look at the nominal yield on the loan and the leverage that can be applied to it.”
Because the senior debt is safe, NXT is able to borrow to create leverage ratios for its funds of about two to one, so that a $300 million fund could be based on $100 million of equity and $200 million of leverage. This allows it to soup up the return on its funds to 9-11 percent, net of fees.
Like other well-managed senior debt providers, NXT writes off very little money from its loans. Over the course of an economic cycle, payment defaults average 3 or 4 percent, says Radway; NXT’s recovery rate, the average percentage of principal and accrued interest on a debt instrument in default that can be recouped, is typically above 80 or 85 percent. It is, naturally, much higher than recovery rates for more junior debt, because senior debtholders enjoy the right to recover their money before junior debtholders.
Senior debt providers can also afford to be extremely fussy because the universe of eager borrowers is so large. “The banks have retreated from the middle market, or are being more cautious, given the regulatory environment they’re in,” says McGonigle. There are, to counterbalance that, “lots of new entrants, but when you look at the size of their funds, non-bank lenders can’t replace the banks’ balance sheets”.
The ability to pick and choose keeps default rates down, because for senior debt holders only the safest borrowers make it past the final hurdle.
“We are incredibly selective,” says Max Mitchell, head of direct lending at Intermediate Capital Group, a specialist asset manager in private debt, credit and equity which is headquartered in London but provides private debt throughout the world. “We do less than 5 percent of the deals we look at, and it takes up to six months to due diligence a business.”
This model is certainly attractive to the broad range of investors that need fixed-income investment to meet their liabilities. For ICG, about 35 percent of private debt investment comes from pension funds, with another 25 percent from insurers. These investors are, says Mitchell, happy to accept the illiquidity inherent in private debt for a certain proportion of their portfolios.
For Audax Senior Debt, McGonigle looks to public and private pension plans, insurers, endowments, religious organisations and high net worth families, but has noticed a rise in interest from European investors. He attributes this partly to the relatively greater strength of the US economy than in many of their home markets, as well as structural reasons.
“Some investors feel comfort in the fact that the US has an established non-bank lending environment, and a bankruptcy code that imposes a more consistent and therefore predictable restructuring process,” he says.
Investors are certainly considering the relative attractiveness of different parts of the world closely, as are the private debt funds in which they invest. A number of observers currently prefer the US to Europe, but Europe is better than Asia, in the eyes of some.
“Spreads have compressed in Asia in the senior debt part of the capital structure, driven by abundant liquidity from Asian commercial banks,” says Edward Tong, Singapore-based senior vice-president and head of private debt Asia at Partners Group, a private debt investment manager based in Zug, Switzerland.
“On a relative basis, senior spreads in US and Europe are more attractive.”
FILLING A GAP IN THE MARKET
Unspectacular firms that require regular return visits are the perfect target for senior debt providers, none more so than the likes of dentists.
“We are big on healthcare services,” says Radway. “For example, we have several dental practice management companies in our portfolios.”
For similar reasons, NXT also likes manufacturers of replacement parts and enhancements for cars. People do not stop spending on these items during bad times, and the number of chains and individual outlets that order these parts from individual manufacturers is diverse: there is no concentration risk.
For the same reason, however, Radway is wary of manufacturers that sell component parts to auto makers. It seems, at first sight, almost exactly the same market, but is very different from the point of view of senior debt providers: car sales fall sharply in downturns, and there is high concentration risk: “If one big customer decides to go somewhere else, they’re looking at a significant decline in revenue” – and stable revenue is what ensures regular debt repayment.