December 1, 2016
Investors are increasingly interested in alternative credit strategies. What objectives are they trying to achieve? What considerations do they have around liquidity, risk, and fees?
Reduced bank lending from traditional credit sources has created a shortage of capital available to corporate and consumer borrowers. At the same time, investors have been searching for alternatives to fixed income public markets. Together, this has resulted in increased investor demand for direct lending strategies and other less liquid credit opportunities (collectively referred to as alternative credit).
Trending strategies available to investors include middle market lending, multi-strategy credit, marketplace lending and other more niche strategies. Strategy investment objectives and considerations were shared by different investment consultants, fund-of-funds, public pension plans and wealth management firms.
Middle Market Lending: Returns vary within the middle market space. Returns of 12-15% are being achieved from collateralized second lien loans and uncollateralized mezzanine loans. These higher yielding opportunities are found on the smaller-end of the market and are available across sectors and geographies, most notably in the U.S. and Europe. Such credit portfolios are normally spread across a diversified mix of loans with durations typically ranging between three to five years, subject to extensions.
On the larger-end of the market, lending opportunities come with lower yields. To achieve higher single digit-to-lower-double-digit returns, leverage is often employed. Leverage is generally obtained from a bank line-of-credit.
There are also "unitranche" strategies that fund loans from across the capital structure, including first-lien loans, second-lien loans and mezzanine loans. These strategies provide a blended yield and may or may not be levered based on the return target.
Middle market lending strategies and niche alternative credit strategies are generally offered via private equity fund structures. As a result, investors generally do not have liquidity for the first part of the fund's life (the investment period). Only toward the last part of the fund's life (the harvest period), when investments are liquidated, do capital balances start being returned to investors. Once all of the capital balances have been returned to investors, the fund will generally be shut down. Many of these fund structures can have lives of three to seven years. Other structures may have lives of 10 to 12 years.
Strategies that blend private debt and public market strategies can be offered through both private equity structures and hedge fund structures. Hedge fund structures often come with one-year lock ups, quarterly liquidity and investor-level gates. As a result, managers with hedge fund structures have to carefully balance the liquidity of their underlying investments with the liquidity provided to investors.
Marketplace lending strategies can be offered via '40 Act interval funds, which provide quarterly liquidity. The average duration of these loans range from six months and two years, and loan amortizations are collected monthly from many thousands of loans. As a result, the strategy has liquidity. That being said, if there were a liquidity crunch, fund-level gates can protect the fund from heavy investor redemptions.
Within private equity portfolios, it is common for portfolio companies with outsized returns to overcompensate for other portfolio company losses. However, private loans do not experience the same outsized returns that private equities do. A few defaults within a private loan portfolio could significantly reduce the expected returns of the portfolio. As a result, when funding middle market loans, the underwriting of each loan is critical.
A thorough underwriting process can include reviewing each loan covenant to make sure that the proper legal protections are in place and understanding how those covenants can be enforced in each jurisdiction. Also, managers should consider having seasoned in-house loan restructuring professionals with the capacity to handle a number of restructurings.
Sponsor participation in deals can be another issue to consider from a risk perspective. Some borrowers may have existing relationships with large private equity managers. These managers (or sponsors) can be very involved in the day-to-day management of these corporations. There are different views on the benefits and risks associated with having private equity involvement.
With marketplace lending strategies, these portfolios consist of many thousands of loans with an average duration of six months to two years. The loans are from borrowers with high FICO scores, and they are spread out geographically. While these factors have eased the concerns about default risk with some investors, there are other investors who are waiting for the marketplace lending space to go through a complete market cycle before deciding whether to invest in the space.
With more niche strategies, risks may be specific to the tangible assets or unique situations that are being financed.
Strategies offered via private equity structures, often come with a 1-2% management fee and a 10-20% performance allocation subject to a hurdle rate. (Managers cannot accrue a performance allocation if the strategy's returns do not exceed the hurdle rate.) Hurdle rates vary and can be 600-700 bps over LIBOR. These structures may also have management fee breaks tied to AUM thresholds.
Those strategies offered via hedge fund structures often come with a 1-2% management fee and a 10-20% performance allocation. Newer launched hedge funds may also include management fee breaks tied to AUM thresholds.
For strategies offered via '40 Act interval funds, they often come with management fees of 1.5%.
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