VIDEO: The direct lending mid-market is ‘priced to death’

Dan Zwirn is chief executive and chief investment officer of US- and UK-based investment firm Arena Investors and former manager of the eponymous multi-billion-dollar hedge fund, D.B.Zwirn & Co. He discusses why he sees trouble looming in the direct lending mid-market due to weak structures, poor security and high prices paid for corporate assets. He also reflects on a lack of information in the leveraged loan market, which is driving some to set up CLO companies in order to obtain better access to data.

AT: Well I’m Andy Thomson, senior editor, Private Debt Investor. Dan, would you like to briefly introduce yourself.

DZ: Sure, Dan Zwirn, CEO and CIO of Arena Investors, a $1.1 billion alternative asset and credit investor.

AT: And you’ve been working on a white paper with a couple of academics from Johns Hopkins and I think that was kind of fleshing out really some of the concerns that you had about the market and looking to back that up with data. There’s a number of areas you’ve identified which could present a problem. One of the areas we’ve focused on a lot is mid-market direct lending. That’s been a very popular area for investors, as you know.

DZ: Yeah.

AT: A lot of competition there, and arguably you’ve seen pricing go up to a pretty high level.

DZ: Yes.

AT: Could you share some of your observations around that in terms of the research you’ve done on the mid-market?

DZ: Sure. Well, you know from a bottoms-up perspective I built one of the early and larger businesses doing that in the United States, and there we were levering companies. Well, first of all we really did that off the back of an observation that regular banks and asset-based lenders weren’t really looking to the quality of enterprise. It was really just the accounts receivable, inventory and machinery. So there were opportunities where we could lend at three, three and half times cashflow and charge, you know, 14 to 17 percent in three-year pieces of paper with two-year duration. That market is now, you know, five to six and a half times cashflow, much weaker structures, much less security lending work for, you know, 60 percent of the compensation. It’s just really been priced to death and that’s further been allowed or propagated or incentivised by the prices people are paying for corporate assets. So, if I’m a lender and it might make me feel good to have lots of equity – cash equity – beneath me, independent of the fact that that cash equity may be paying a price for the asset that’s far too high. And, as an asset owner, the fact that someone’s willing to lend me way more money than I should think I should get that at way cheaper of a price might allow me to think “well jeez, I’m paying a lot, but my financing’s so cheap that maybe it’ll kind of work”. So those two together prop each other up and really encourage an explosion of activity in that area.

AT: And, you know, we cover leveraged loans and CLOs as well. These are also kind of pressure areas, you know, your argument being that in leveraged loans the quality of the paper just isn’t there. And then CLOs, you were telling me that, you know, it’s kind of being used almost like an information or a transparency play because of the opaqueness of leverage loans.

DZ: Yeah. Look, as someone who’s transacted in leveraged loans over the last 20 years, there were times where if you were interested in a name you could call up a dealer and just say “give me all the information that’s available and I’ll make a judgement for myself and maybe there’s something to buy”. Now it’s really much more closed, so unless you’re already invested in the name it’s hard to get information on the name. And so if you’re really trying to optimise you might say “well, how do I get the most information while exposing my capital the least?” Well that might be to start a huge levered CLO management company where other people will take up all parts of the stack so I can buy lots and lots of loans and keep lots and lots of data, even though I have billions and billions of AUM. Otherwise, they could buy those loans. Why use my money for when they’re at par when I can get all the information when they’re par and use my money when they’re at 50? Not that we are doing that, but it’s – there’s a notion that certain market participants might be.