The tightening of regulations around the world is prompting banks to offload a variety of financial assets onto the capital markets. This disintermediation process is giving investors access to investment opportunities that were previously the exclusive remit of banks. We believe that the investments being created by banks' partial withdrawal from lending offers attractive potential returns and supply and demand dynamics. While many investors are aware that disintermediation is taking place, we believe that some remain confused about the scale and timing of the opportunity. While conventional wisdom holds that this opportunity has played itself out, we believe that evidence shows this not to be the case. Over the next three years, the combination of maturities in the institutional loan market and private equity capital commitments means that supply in this area will easily exceed €100 billion in Europe, even in the absence of further European bank deleveraging. From the perspective of an institutional investor, we consider the liquidity, expected returns and other characteristics of these securities and offer practical approaches as to how they might best be incorporated into a portfolio.
Since the financial crisis, banking regulations have been tightened across much of the world in order to reduce the risk of another system failure. The myriad of inter- and intra-national regulations has incentivized banks to reduce their holdings of risky assets. This has created an opportunity for investors in capital markets to lend directly to companies, something banks had previously been almost alone in doing. Banks need to dispose of a large volume of assets, but the pool of potential capital market investors for some of these direct lending opportunities is limited. We believe this creates an attractive supply-demand dynamic and offers the potential for attractive returns.
Investors are aware of this opportunity. However, we think that many hold misconceptions about it because of the opaque nature of the disintermediation process, and the unfamiliar and heterogenous nature of the assets involved. In particular, we believe that investors incorrectly assume the opportunity has been missed and offer evidence that this is not the case. We also think that few investors have had the opportunity to fully understand the practical characteristics of the asset class. Our objective is to provide these details, and to explain how it might be incorporated into an institutional portfolio.
The Disintermediation Story So Far
The Basel III and Dodd-Frank regulations are the most prominent examples of a raft of regulatory actions designed to reduce the riskiness of banks and to prevent another banking crisis. The increased regulation makes it more expensive and difficult for banks to lend and they have responded by planning to reduce future lending to the private sector and by attempting to sell off existing lending arrangements as syndicated loans, direct loans or Collateralized Loan Obligations, (CLOs).1 For a company seeking capital, the alternative to borrowing from a bank is to borrow in the capital markets by issuing securities such as bonds or syndicated loans. Many larger companies can arrange bond issues and they have numerous willing lenders in the markets. Disintermediation presents neither a significant challenge for them, nor a new opportunity for investors.
We believe that the most attractive opportunities resulting from disintermediation are for direct lending to small and medium-sized companies, which have traditionally relied heavily on bank lending. These companies' borrowing needs are not large enough to make issuing bonds a viable option, but they still need funds. Direct lending means investment managers make loans to these companies on a one-to-one basis. These investments are likely to be illiquid, with no reliable secondary market. Investors maybe attracted to direct lending because of the likely imbalance between the significant number of would-be borrowers, often with an inflexible demand for funds, and the small numbers of lenders. But many of those potential investors have difficulty stomaching the illiquidity and unfamiliarity of this type of investment.
Figure 1 // Structure of the Direct Lending opportunity
The imbalance between supply and demand is likely to be most acute in Europe and we believe investors interested in this opportunity should focus there. Bank lending has historically been the dominant source of private sector borrowing in Europe, and debt markets are relatively underdeveloped compared to those in the U.S. So far, there has been little construction of CLOs or other securities that might increase the capital available for corporate lending. In the first half of 2013, according to JP Morgan, European banks have created €2.4 billion worth of CLOs, far below the €35 billion they issued in the peak year of 2007.
Most Of The Required Disintermediation Has Yet To Occur
Investors considering direct lending may believe the opportunity has already passed them by. The disintermediation process is not particularly transparent, and few if any aggregated data sources show its progress. However, examining the situation in Europe, we do not think the supply and demand imbalance that makes these investments attractive has eased. Generally, investors have not positioned themselves to meet this opportunity, and asset management companies have offered them a limited number of vehicles for doing so.
We believe that the opportunity created by disintermediation continues to exist because banks have not yet begun to dispose of the bulk of the loans they will need to offload. Many of the Basel III regulations go into effect between 2016 and 2019, and banks have several reasons not to immediately start the process of bringing themselves into compliance. They may believe that over time, markets will become more welcoming to the assets the banks must sell and will demand less of a discount. They may also wish to start de-leveraging once their capital positions have improved. Selling riskier assets now could force them to realize losses versus the book value and make their capital situations look worse. In a 2012 survey of bankers2, most agreed that the bulk of de-leveraging in Europe would not occur in the near future (see chart below). A similar survey of investors suggested that the de-leveraging process would most likely take place between 2015 and 2017. The announcement at the start of this year that the Liquidity Coverage Ratio aspect of the Basel III regulations has been delayed may further extend the process.
Figure 2 // When will European bank de-leveraging conclude?
The asset management industry has thus far shown little more eagerness for disintermediation than have the banks. Many asset managers are not equipped to manage this novel investment opportunity, and some investors are unsure how best to take advantage of it. As of 2012, they had allocated an estimated €60 billion3 to take advantage of the expected €500 billion in European bank asset disposals. We therefore think that the attractive supply and demand dynamic, which drew investors' attention to this opportunity in the first place, still exists.
Extra Spread Is Equivalent To Several Levels Of Subordination
Quantifying returns for direct lending is difficult because the asset class itself is still forming. That is because it largely consists of relatively small, nonpublic companies, and because there is no public market for direct lending arrangements. However, we can use public data and anecdotal evidence to broadly outline prospective returns. Those outlines should be sufficient for investors to evaluate the opportunity and to determine how direct lending might fit in their portfolios. Though the pricing of the direct lending market is not transparent, the premiums and discounts for seniority or subordination in the corporate bond market can provide insights into the current pricing of the syndicated loan markets and the expected premium for illiquidity.
To look at how the capital structure is priced, we examined instruments spanning most of the corporate capital structure, which have a relatively high degree of price transparency. Figure 3 shows bond relative spreads for both USD and EUR bonds before and after the financial crisis. This allows us to observe the material increase in premia for subordination. Comparing USD and EUR shows that Europe, where the bulk of the de-leveraging process has not yet played out, has the larger risk premia differentiation across the various levels of the capital structure.
Figure 3 // USD and euro bond spreads before and after the financial crisis
Source: BNY Mellon Research, BofA Merrill Lynch Investment Grade and High Yield Corporate Bond Indices
Data in Figure 3 are calculated using statistics from cross-sectional regressions of bond spreads against various bond characteristics: sector, credit rating and seniority (priority of repayment in the event of default) . The bond universes are BofA Merrill Lynch indices, investment grade and high yield, for USD and EUR respectively. The column labeled "BBB to BB" is the pickup in yield that one would gain by moving from BBB to BB rated bonds. The column labeled "Secured to Senior" is the pickup in yield that one would gain from moving from secured debt to senior unsecured.4
The "Secured to Senior" column shows the markets granting a larger discount for seniority in the capital structure. In the U.S., the spread widened by 22 basis points, from -9 to 13. The spread for Euro-based bonds widened by 29 basis points, from 4 to 33, despite seniority already being reflected in the rating. Even after accounting for both industry and rating, public capital markets are offering a significant discount to buyers of subordinated debt. Consistent with our assertion that the squeeze on borrowers in Europe will be much tighter; the premium for subordination is larger in Europe, 33 versus 13 basis points.5
The next step is to judge where loans are being priced relative to bonds. Loans are typically senior to bonds in the capital structure; they have higher priority in the event of default. Therefore, their credit spread should fall between secured and senior bonds. However, the spreads on loans are similar to senior bonds. Currently, spreads on loans rated BB or B are around 350-450 bps above LIBOR. Senior bonds of comparable credit quality for non-financial issuers are priced 300-450 bps over LIBOR.6 Based upon these estimates, loans clearly offer a competitive credit spread. Their spreads are comparable, but all else being equal, they are expected to have a higher recovery the event of default.
Finally, one should look at multiple sources to gauge the liquidity premium. We do this by evaluating aggregate Eurozone loan data, liquidity premia in other asset classes and anecdotal evidence.
Figure 4 // Liquidity spreads – private versus public markets
Aggregate eurozone loan data, which include syndicated and large company loans, indicate a yield spread of 25-75 bps over publicly traded bonds of comparable quality. For general liquidity premia, our experience across asset classes is that liquidity is nearly always worth 100 bps. More specifically, we have found that in private equity, when adjusted for leverage, a 200 bps liquidity premium is available compared to publicly traded equity. Anecdotal quotes from participants in direct lending support our estimate that direct loans currently offer a liquidity spread of well above 100 bps, relative to the more liquid syndicated loan market.
In the absence of market prices for spreads in direct lending, we think that the advantages of direct lending over publicly traded debt can be characterized as follows:
- Markets are pricing an extra premium for subordination in the capital structure, boosting yields.
- Loans are currently attractively priced relative to comparable bonds. They have similar yield, but they are typically superior in the capital structure, and therefore investors may expect a higher recovery value in event of default.
- The illiquidity premium of direct lending results in a yield increase which is equivalent to several levels of subordination in the capital structure.
In summary, the compensation for direct lending appears to offer more than adequate compensation for the credit and liquidity risk.
Incorporating Direct Lending Into A Diversified Portfolio
A pooled fund of direct lending assets, rather than a segregated account, is likely the only available way to gain exposure to this opportunity. Diversification is important, and a pooled fund structure allows an investor to diversify across a range of direct lending assets and avoid excessive concentration of issuer and other risks. Investors may prefer segregated accounts in other asset classes, but the benefit is limited in direct lending because those accounts do not easily accommodate individual clients constraints.
The method an investor uses to incorporate direct lending into a portfolio will partly depend upon their tolerance for adding illiquid assets. Currently, we believe that sacrificing liquidity provides investors with an attractive gain in expected return. Therefore, investors who can sacrifice liquidity without jeopardizing their ability to meet liabilities should do so. However, even investors whose allocation to illiquid assets is already as high as they feel comfortable with may improve their portfolios by re-allocating some of the illiquid portion of their portfolio to direct lending. Below we outline asset allocation changes we believe can improve expected returns and/or reduce risk.
Direct Lending As A Replacement For High Yield Bonds
High yield bonds have enjoyed significant gains over the past few years, but credit spreads have now reached relatively compressed levels. Even after recent increases, government bond yields are far below their historical range. Although default rates do not appear to threaten expected returns, this combination of low interest rates and tight credit spreads means that loans are competitive with high yield bonds on an absolute basis as well as adjusted for risk.
Replacing high yield bonds with loans gives an investor a competitive yield, a superior position in the capital structure, and a floating coupon rather than a fixed one. The price of these advantages is a reduction in liquidity. In terms of spread to LIBOR, we currently see direct lending as being priced at least 120 bps higher than high yield, for a similar credit rating. Furthermore, the superior claim on capital in the event of default and the floating nature of the coupon help to reduce default risk and interest rate risk, respectively. The two main threats to investors' capital are thereby partially mitigated. We expect that the higher spread will persist for some time and that the liquidity premium for direct lending is unlikely to disappear. The spread advantage of loans over bonds will persist until structural issues such as settlement and pricing match those of bonds and investor flows and issuance reach levels comparable levels to bonds.
Switching From Other Illiquid Assets Into Direct Lending
For investors who have already reached their maximum allocation to illiquid assets, we believe there may be advantages to partially switching from other illiquid assets into direct loans. Such changes would be subject to the schedule at which other illiquid allocations could be reduced, since these assets are by definition not readily realizable. Switching from private equity to direct lending would likely increase diversification, reduce total intra-portfolio correlation and increase liquidity by shortening lockup periods and reducing contingent commitments. Switching from hedge funds to direct lending could offer more security regarding expected returns.
Figure 5 // possible asset allocation switches to accommodate the direct lending asset class
1 Syndicated Loans, in contrast to the direct loan asset class that is the focus of this article, are arranged between the borrower and a number of other par ties and of ten have a somewhat liquid secondary market. Collateralized Loan Obligations, or CLOs, are structured products that permit investors to own a defined part of a pool of loans. A good primer to the asset class is published by the Milken Institute.
2 Deloitte; Capital gain, asset loss: European bank de-leveraging.
3 PwC; European Investor Insights 2012
4 For the risk premia in Figure 3, most of the junior securities are issued by companies that also issue senior securities. Therefore, the estimated risk premia are a fair representation of the cost of seniority after taking into account other factors such as sector and rating. For mid-level companies, first lien loans might comprise the entire capital structure above equity. Therefore, an asset manager will take into account the lack of a cushion from other creditors when assessing a fair value spread. This additional feature of loans to mid-level companies will be considered by an asset manager and should be reflected in the spread received by investors. In practice, however, the blending of the capital structures for mid-level companies should not be a significant distortion relative to the spread components. Senior bonds make up a large percentage of the capital structure. For the broad US and European debt markets, senior debt is over 85 percent of the issuance, according to BoA Merrill Lynch. For HY debt, senior bonds are 70-90 percent of the unsecured debt across both European and U.S. companies.
5 Obtained from Bloomberg, as at end-June 2013
6 One difference between bonds and loans which is not accounted for in this analysis is the callability of bonds versus loans. Bonds typically have a call price of 1-3 points above par, but loans are callable at par. For consistency, all analyses presented here are done using OAS versus swaps in order to minimize any potential mismatch between bond and loan spreads.
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