These days, when covenants in the US private credit market seem, at times, to be heading the way of the dodo, it is refreshing to talk to Michael Gross, co-founder of Solar Capital Partners in New York.
Asked whether the asset-backed loan market, one of the firm’s specialities, has seen a rollback in covenant protection that mirrors the mainstream market, Gross replies: “Not at all. It’s never entered into discussions.”
Solar even makes money off them for its funds by charging amendment fees when they are breached. This happens “with some frequency”: covenants are set according to management plans and even a small deviation can trigger a technical breach allowing the lender to re-underwrite risk and adjust the borrowing base.
These fees, plus others like collateral monitoring charges, make up part of the targeted internal rates of return of 8 to 14 percent on Solar’s ABLs, with most at between 10 and 12. However, the bulk of the IRR comes from the coupon, always a floating rate except for equipment finance, plus an original issue discount.
Explaining why Solar has not experienced an impetus to roll back covenants, co-founder Bruce Spohler cites above all the high barriers to entry, which limit the amount of capital competing for borrowers. Chrystalle Anstett, co-head of private credit at Eaton Partners, the Connecticut-headquartered placement agent, makes a similar point, noting there are only a handful of players within each ABL.
“Because there’s not as much competition, there’s less erosion of terms, better pricing and more attractive yields,” she says. “It’s basically the opposite of what we’re seeing in regular direct lending.” She adds that investors are looking for “at least 12 to 15 percent net return” from ABLs.
If the power remains with the lender rather than the borrower, it is not surprising that ABLs are growing in popularity among limited partners. In a 2018 end-of-year survey by Eaton of 75 private credit investors, 92 percent planned to allocate to asset-based credit in 2019. She gives container ships, agricultural machinery and trucks as examples of assets in which limited partners have shown interest.
Higher return, higher risk?
Asset-backed lenders dispute the idea that if returns are higher than for much of conventional direct lending, the risk must be greater too. Spohler of Solar quotes data from the Loan Syndication and Trading Association and others showing that over the past 20 years, defaults have averaged a little over 1 percent (with a peak of only 2 percent or so at the height of the credit crunch), and average realised losses of only about 50 basis points. Solar’s rates have been lower still. He credits the paltry average rates for ABLs to asset-backed lenders’ insistence on full borrowing base covenants and the low peak rate to the shorter-term duration of ABLs and rapid turnover of collateral. Solar’s ABL durations average between 18 months and three years, depending on the market.
Solar’s Gross says he has seen very few new players move into the ABL market, even at this point in the cycle. He argues that because of a dearth of expertise, new players tend not to show the necessary discipline. They might, for example, gradually increase the amount they lend against the same collateral, to a dangerous point. He also adds that underwriting, monitoring and knowing when to agree to extend a credit facility through an amendment require years of experience, encompassing a wide range of different industries.
Aside from ABLs, Anstett of Eaton identifies a general interest in other niche strategies. Many of these niches have been prised open for alternative lenders by the withdrawal of the banks, which have been driven by regulation to draw in their horns. Take trade finance as an example.
“One rule effectively opened up the entire trade finance market for investors like us”, says Carlos Mendez, co-founder of Crayhill Capital Management, a New York-based private debt manager specialising in niche loans, often with a structured component.
This was the new rule, imposed after the credit crunch, that if a borrower lacked a credit rating by an external agency, the bank would have to allow for a full capital charge on their loan. This creates opportunities to provide trade finance to large companies with strong businesses. Mendez cites the example of Goya Foods – not a client of Crayhill – a $1.5 billion-revenue company that supplies delis across the country with Hispanic cuisine. Even an olive needs trade finance sometimes.
Niche is in
Niche markets are also attractive because they do not behave like other markets. Anstett of Eaton sees the concepts of niches and non-correlating assets as interlinked. She notes that in Eaton’s recent survey, when asked to devise their own description of their planned private credit strategies for 2019, 77 percent of respondents included the words “uncorrelated” or “niche”. Mendez of Crayhill echoes this, saying that investor interest in his firm’s niche strategies “isn’t necessarily because of increased risk in private loans. A lot of it has to do with seeking uncorrelated returns.” He says that although mainstream private loans and high-yield bonds show high correlation with each other, Crayhill’s loan book shows “very low” correlation with high yield, though he declines to give a precise number.
Another niche strategy endorsed by Anstett of Eaton is the equity tranches of collateralised loan obligations: securitised pools of senior secured corporate loans, usually sub-investment-grade. She notes that targeted returns are currently almost 20 percent, and realised historical returns have outperformed public equity, private equity, public debt, high-yield debt and leveraged loans “by a significant margin” over the past 15 years. However, critics say that new CLOs have been subject to the same aggressive covenant liberalisation as the mainstream private credit market.
Investors often discuss the equity risk premium, illiquidity premium, and other premia, but Anstett has a new one: the “confusion premium” that limits capital invested in CLOs and therefore boosts returns. The confusion arises from the fact that many investors mix up CLOs with CDOs (collateralised debt obligations) of yesteryear, which included securities based on sub-prime mortgage loans that defaulted during the credit crunch.