Alternative Investments 2.0

3 Return Drivers of Private Debt Investments

Investors considering the private debt asset class often raise the question “To what risk does an observed interest margin relate?” Their point of reference would typically be the gross interest margin that a local bank might offer to a corporate borrower. However, in countries with a competitive banking landscape and bank debt priced at around 250 bps to 300 bps interest margins for leveraged buyouts, a 600 bps margin for direct lending transactions appears to be risky. However, a more differentiated approach and analysis is needed to fully appreciate the attractive return and risk drivers of direct lending. The aim of this analysis is the attribution of the interest margin to specific risk factors.

An important requirement to do so is the availability of data for a notoriously opaque asset class. The analysis that follows is based on a comprehensive data collection and includes more than 5,100 loans originated from 2006 to 2018.

Exhibit 8 illustrates the findings of the interest margin decomposition. The analysis not only helps in understanding the risk/return drivers but also supports the efficient sourcing of loans and portfolio construction.

Exhibit 8: Risk premia decomposition of Corporate Direct Lending

Source: StepStone Private Debt Internal Database, based on more than 5,100 US loans originated between 2006 and 2018

3.1 Base Loan-related Factors

The base loan factors primarily relate to the variables present in a loan structured by a bank for a particular borrower. In exhibit 8, the base loan is defined as a core sponsored covenant-lite first-lien loan issued by a US utility company with an EBITDA between USD 30 million and USD 50 million, an LTV below 40% and leverage above 6x. The return of such a loan can be broken down as follows:

 Risk-free base rate: This would be the floating base rate over which the margin is added; LIBOR is used as the base rate for a majority of loans.

 Credit premium: A portion of the interest margin will be related to the borrower’s creditworthiness. If the bank deems the borrower to be of higher credit quality, a lower premium will be charged to reflect a lower risk profile.

 Illiquidity premium: There is no active secondary market for loans made to middle-market companies. Hence, loan pricing includes an illiquidity premium to compensate lenders for the risk that holding these assets implies.

3.2 Direct Lending Specific Factors

Financing solutions provided by direct lending GPs tend to deviate from a bank-style base loan. As a result, they can tap into additional return drivers.

 Capital structure: The more junior a loan is positioned in a company’s balance sheet, the greater the probability that its nominal amount is not covered entirely by the borrower’s enterprise value. Also, a lender taking on a second lien or junior position has less control over the recovery process. Therefore, a risk premium is attributed to the lender’s position in the capital structure.

 EBITDA: Direct lenders consider a borrower’s EBITDA when estimating credit risk; a lower EBITDA typically equates to lower creditworthiness. Several factors can affect a company’s EBITDA, including market share, customer concentration, and cash flow stability.

 LTV: As with capital structure, the risk for the lender increases with the LTV ratio. Direct lenders seek greater compensation for loans that are less collateralized.

 Leverage: The more leverage a company uses, the lower its ability to service that debt. Not surprisingly, highly leveraged transactions incur a premium. Conversely, our analysis shows that transactions using very little leverage also command a premium. In our experience, this situation tends to arise in lending to smaller companies with less solid credit metrics, as noted above, or to companies in cyclical sectors.

 Covenants: Direct lenders can often put in place covenants to fit each borrower’s risk profile. This flexibility comes at a cost: Fewer covenants can equate to an additional risk premium.

 Sponsor/non-sponsor: Lenders often require a risk premium for lending to non-sponsor companies. Sponsor-backed companies typically have better financial reporting and corporate governance, as well as stronger management teams. Sponsors’ rigorous due diligence process provides lenders with additional confidence in the company’s business plan and ability to service debt. Lending to non-sponsor companies typically requires more time and effort in due diligence. Consequently, lenders often seek an additional compensation premium for their work.

 Strategy: Lenders specialising in complex situations also command a risk premium for their deeper sector expertise or the additional work needed to complete the transaction. They also have more freedom to charge a “scarcity premium” given the lower number of financing options available to borrowers in these situations.

3.3 Portfolio Positioning through the Credit Cycle

Determining the relative value of a particular market segment or capital structure through the credit cycle requires a closer look at its performance over time. This provides an investor with the necessary information to decide which portfolio rotations are sensible given a specific market outlook. To demonstrate the importance of a good positioning in the capital structure as the cycle evolves, we analysed distributions of IRRs and loss rates for pre- and post-GFC periods.

Using the resampling methodology, we randomly selected 100 loans from our proprietary private debt database to build a portfolio. We then calculated the IRR of each randomly selected portfolio and repeated this process 100,000 times to obtain the IRR distribution for each strategy.

Exhibits 9 and 10 illustrate the importance of a good positioning through the cycle. The pre-GFC period is characterised by a platykurtic IRR distribution for second-lien/mezzanine loans, demonstrating the sector’s higher risk profile, particularly in periods of market stress. Such a distribution also complicates portfolio construction, since expected returns are harder to derive and less robust.

Exhibt 9: IRR Distribution by Market Segments pre-GFC and GFC vintages (2005-2009)

Source: StepStone Private Debt Internal Database

Exhibit 10: IRR Distribution by Market Segments post-GFC vintages (2010-2017)

Source: StepStone Private Debt Internal Database

Looking at the first percentile of these distributions (i.e., the 99^th percentile Value at Risk), one notices that the values in the first-lien segment vary from 4.5% to 5.5%, whereas the second-lien value is 1.5%, showing the risk carried by junior capital instruments. Nevertheless, these figures also illustrate the defensive nature of private debt investments because the values stayed positive even for second-lien loans.

In the post-GFC period, riskier instruments benefited from the economic expansion whereas first-lien instruments demonstrated their robustness through the cycle and outperformed their pre-crisis returns. In both periods, the upside potential of the upper middle market was limited but the sector is important in the portfolio construction process as target returns have a higher probability of materializing. Among the three first-lien market segments, lower-middle-market loans offer the best relative value across the cycle. Indeed, they delivered higher returns in both the pre and post-crisis periods without exposing investors to excessive volatility.

4 Risk Mitigation and Success Factors When Investing in Private Debt

There are a few key success factors investors should consider when investing into private debt. To benefit fully from these factors, two main drivers are crucial: implementation efficiency and access to high-quality data.

An efficient implementation process ensures high and rapid deployment levels as well as effective cash management. These two factors combined improve the US-dollar return at a given level of capital commitment. Also, granular and reliable data ensure that investment decisions are based on proper insight into the strategy and characteristics of each GP considered.

4.1 Market & Loan Level Data

Given the nature of private markets, access to transaction-level data is less straightforward. Close interaction with GPs and other market participants can provide data for investors to identify market trends and assess a GP’s strategy successfully. Gaining information on deals previously originated by a GP can help identify the market segment in which the manager operates. Knowing a GP’s “sweet spot” allows investors to avoid undesirable risk- factor concentration or select a GP based on how well it fits the portfolio’s broader objectives.

Data on individual loans are harder to obtain and require a closer relationship with the originating GP. Still, this level of granularity is essential if we are to effectively compare managers. Exhibit 11 illustrates this point by providing a clearer picture of the segments in which different GPs source most of their transactions. This is an important tool for manager selection and monitoring as well as for portfolio construction.

Exhibit 11: Average Yield and EBITDA per GP

Source: StepStone Private Debt Internal Database

4.2 Investment Control

In recent years, the amount of capital as well as the number of GPs in the market have grown significantly. This increase in competition has led to an environment that generally favours borrowers. In that regard, investment guidelines are a useful way to prevent managers from chasing unattractive deals. With these guidelines, thresholds can be applied to certain credit metrics such as leverage, LTV or effective covenants.

Exhibit 12 demonstrates that covenants can effectively protect lenders. Indeed, imposing just one covenant can reduce losses by more than half on average, based on historical figures. Covenants are also helpful to identify the borrower’s underperformance earlier thus mitigating the loss rate.

Exhibit 12: Average Loss Rate by Number of Covenants for Corporate First-Lien Loans (2004-2016)

Source: StepStone Private Debt Internal Database, based on more than 8,000 US and EU first-lien loans

4.3 Lender of Record

Being the lender of record (e.g., through co-investments or managed accounts) further strengthens the position of investors. The lender of record owns the loan, has a direct relationship with the borrower, and reserves the right to enforce, settle, compromise, amend the loan, or sell a participation. Participants, on the other hand, have no direct rights under the loan agreement; they can neither enforce the loan nor proceed against the collateral. In most instances, the borrower does not even know the participant exists.[11] The ability to control and drive negotiations with underperforming companies determines the final recovery.

4.4 Deployment

When investors evaluate GPs’ performance and track records, they often look at the managers’ gross and net IRR. However, it is equally important to assess the deployment rate at that IRR, as this dictates the absolute cash return to the investor. Simply put, if a GP cannot identify enough transactions, an investor’s capital sits idle in a bank account where it provides low or even negative returns.

As can be seen in exhibit 13, having the ability to put capital to work sooner leads to significant differences in the cumulative US-dollars-earned amount over the relevant period. These differences mostly stem from different implementation strategies. The chart compares the US-dollars earned on capital committed under three different investment scenarios: an evergreen vehicle, a closed-end vehicle and a single fund.

Exhibit 13: Cumulative US-dollars-earned Comparison

Source: the estimates for the evergreen platform and the closed-end platform are based on StepStone vehicles and on Preqin data for the single fund

4.5 Flexibility

Investors should consider an investment structure that provides the flexibility to shift allocations from one GP to another. This cannot be achieved with investments in funds but requires a Separately Managed Account (SMA) with individually negotiated terms. The need for flexibility may be driven by return, risk, regional focus or capital deployment considerations.

Investing through a flexible SMA platform on which LPs’ commitments can be shifted between GPs allows investors to manage their portfolio based on exposure rather than commitments. By targeting an optimal deployment level, investors can avoid opportunity costs faced in a traditional fund rollover strategy across vintages, as demonstrated in exhibit 7.

4.6 Diversification

Direct lending investors typically seek stable returns at a defined target level, looking for neither excess returns nor excessive losses. As in public markets, diversification is the simplest and cheapest way to reduce risk within a portfolio. This is even more important for investments such as private debt. Only a handful of managers have track records that precede the GFC, which makes it hard to assess how well a given GP may perform throughout the economic cycle.

In light of private debt’s general illiquidity, using variance of returns to illustrate this point is hardly sensible. To estimate the asset class’s diversification benefits, loss rate and its associated variance are far better metrics. Similar to the public market, the more loans within your private debt portfolio, the lower the loss rate variance for a given target return.

To illustrate the diversification benefits based on the loss rate variance, we used our proprietary database to simulate loss distributions for different portfolio sizes, based on a resampling method like the one used to illustrate section 3.1.3. As one can observe in exhibit 14, the greater the number of loans, the narrower the distribution becomes. The tail risk also diminishes as the number of loans in the portfolio increases.

Exhibit 14: Loss Rate Distribution as a Function of the Number of Loans within a Portfolio

Source: StepStone Private Debt Internal Database

Irrespective of the number of loans within the portfolio, the expected loss remains the same. However, the 99th percentile of the loss distribution falls significantly with the number of loans. This is one more example of the importance of diversification and the benefit of investing with multiple GPs. Indeed, having access to transactions sourced by various managers enables investors to participate in enough deals and build a well-diversified portfolio.

The COVID-19 pandemic provides another example of the importance of diversification. The lockdown and social distancing measures imposed by most governments had a dramatic effect on some businesses such as restaurants, leisure or retail shops whereas others benefited from the situation. Had it been a computer virus instead of a biological one, the affected sectors would have been very different. Diversification remains the cheapest and most effective hedge against these types of risk. StepStone recommend using investment guidelines (see section 4.2) to ensure a proper sector diversification in the portfolio.

4.7 Workout Capabilities

Investors need to undertake detailed due diligence on the GP’s workout capabilities and experience during previous cyclical downturns. Workout expertise is critical to maximizing recovery. GPs serving as either the sole or lead arranger are often in a better position to succeed in such a situation than a club of lenders. In addition, our analysis from our proprietary database shows that sole and lead arrangers achieved loss-adjusted returns 80 bps higher than participants in club deals with five or more lenders. We believe this is due to their enhanced negotiating power vis-à-vis the borrowers.

4.8 Economies of Scale

Investors have the ability to improve their negotiating power with GPs and reduce fees through economies of scale. They can do this, for instance, by investing through a platform that aggregates their capital.

Few investors have sufficient capital and market knowledge to implement the success factors described in the previous chapter on their own. Having the flexibility to switch commitments between managers and strategies is essential to implementing a high-conviction view based on data analysis and manager selection. We are convinced that investment guidelines are the best instruments to avoid situations that could jeopardize the sustainable growth of the asset class through multiple cycles. Because of the rapid growth of private debt in recent years, smaller investors have encountered more difficulties in discussing customised investment solutions with GPs.

Nevertheless, we strongly discourage investors from compromising on quality and returns because of their size. We believe that investors will collaborate more closely with business partners to regroup commitments. Hence, they will be able to access prime managers, implement their vision, allocate capital more efficiently and, most importantly, diversify their exposure.

Bibliography

Fang, L./Ivashina, V./Lerner, J. (2015), The disintermediation of financial markets: Direct investing in private equity, in: Journal of Financial Economics 116/1, 160-178.

Jones Waldo Holbrook & McDonough (2013), Loan Participation or Assignment; What's the Difference?, https://www.martindale.com/banking-financial-services/article_Jones-Waldo-Holbrook-McDonough-A_1971368.htm, access: 7 October 2020.

StepStone (2014), Co-Investments: Good for Your Portfolio’s Health?, https://www.stepstoneglobal.com/news-press/co-investments-good-for-your-portfolios-health/, access: 7 October 2020.

Fußnoten:

[1] Federal Financial Institutions Examination Council, as of March 2020.

[2] Preqin, as of July 2020.

[3] Total Market Size for US Direct Lending based on Reuters data and StepStone estimates. European Direct Lending data based on StepStone estimates.

[4] StepStone estimate.

[5] First-lien lenders have the priority claim on the company value, holding debt that ranks ahead of second-lien loans and other subordinated lenders, for example.

[6] Credit Leverage loan indices as of June 2020. Par value of CS US LLI: USD 1.26 trillion and Par value of CS EU LLI: USD 352 billion.

[7] PWC, Portfolio Advisory Group (Restructuring Europe’s banks) – Market Update, Triton Presentation.

[8] Fang/Ivashina/Lerner, 2015.

[9] StepStone, 2014.

[10] StepStone estimates.

[11] Jones Waldo Holbrook & McDonough, 2013.

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