Middle-market loans are posting attractive current yields with bond-like correlation to broader equity markets. Fund managers access these loans in one of two ways: origination and syndication. As you do your due diligence on the potential benefits of both, ask yourself: why choose just one?
Lending paradigm shifts away from commercial banks
Commercial banks’ willingness to originate and hold significant amounts of leveraged loans to middle-market companies has abated over the last 30 years. First, the 1990s brought a wave of bank consolidation with the likes of Continental Illinois National Bank and BankBoston merging into Bank of America and Bank One, and First Chicago becoming a part of JP Morgan Chase.
Then, post-financial crisis regulatory changes reduced those big banks’ appetite for holding these loans. Dodd-Frank (2010), the Leveraged Lending Guidelines (2013), and Basel III (2014) ramped up capital requirements and reporting burdens on banks, which in turn shifted lending further up-market to larger borrowers. In 1994, foreign and domestic commercial banks held 71 percent of the leveraged loan market compared to just 9 percent in 2017.1 Many of these banks have maintained origination and syndication platforms with a focus on larger, more liquid loans. They simply no longer have the sourcing infrastructure to access the middle market.
Non-bank lenders originate or syndicate
Non-bank lenders have stepped up to fill the void in two ways. Those with the expertise and bandwidth will go straight to a private equity sponsor or middle-market company owner to originate a loan, offering funding without the use of an intermediary. Key providers or buyers of direct loans include public and private alternative asset managers, business development companies, mid-market focused Collateralized Loan Obligation fund managers, hedge funds, and insurance and finance companies. These providers vary greatly in size and experience – so tread lightly with a wealth of research in toe!
Alternatively, syndication involves a group of lenders who each fund a piece of a loan to a single borrower. This process most often occurs when a borrower needs excessive capital that one lender can’t provide or the loan is outside the scope of a lender’s underwriting capacity. The syndication agreements are typically managed through a corporate risk manager who enforces all contractual obligations, including compliance reports and repayments throughout the duration of the loan. This structure is often used in corporate financing as firms seek loans for mergers, acquisitions, buyouts, or CAPEX projects.
Why each strategy may make sense
Directly originated loans may offer non-levered total returns made up of a floating-rate base rate over a spread, typically to three-month LIBOR. They also pull in upfront origination fees plus call protection, potentially enhancing their return profile. These loans may also help curb overall portfolio volatility since they are relatively uncorrelated to broader market movements, and tend to have strong upfront investor protections, since the lone originator is directly negotiating the terms. Directly originated loans seek to reduce risk through maintenance covenants, due diligence, and secured lending terms. Covenants are a crucial differentiator, especially as 75% of broadly syndicated transactions have been structured as covenant-lite since 2013.2
Syndicated loans lower a borrower’s cost of capital due to the valuable risk-sharing benefits from loan sales on the secondary markets. Institutional investors such as hedge funds and private equity funds started entering the syndicated loan market shortly after the introduction of loan ratings by Moody’s and S&P in 1995. The development of this secondary market injected liquidity into these loans, which attracted a growing institutional investor base that even further fueled increased market liquidity.
Aside from liquidity, size also matters when measuring risk. Directly originated deals generally include smaller borrowers, potentially increasing default risk. These companies may rely on a single product line, or have an unproven unique selling proposition. Syndicated loans, however, are generally used as financing for much larger companies who may be more established. This is one way to assess credit risk, as these companies have a long operating history to analyze. Also, in the event of default, a borrower with a company structure to reorganize may offer more robust recovery rates.
Syndicated loans may also offer a larger opportunity set to investors. While important, success isn’t always based on preliminary due diligence. Credit-focused, closed-end interval funds, due to their gated liquidity provision, may be able to identify short-term market inefficiencies to generate returns even if the long-term outlook for the credit is mixed. Also, active managers in the secondary market may be able to identify market inefficiencies that lead to a better return on a par exit over a shorter time frame. Unlike direct origination, syndicated loans are not always infancy-to-maturity holds.
Finally, while direct originators are the sole manager and underwriter of their loans, participating in the syndicated loan market have help diversify a loan portfolio across managers and underwriters. Often, an underwriter will have a specific geographic or industry-focused niche that may help limit a portfolio’s concentration risk.
While both loan types may offer attractive yields with low correlation, they take different paths to get there. Here’s the easiest way to think about what each offers.
Building a loan portfolio for today’s environment
Despite the long duration of the current credit cycle, corporate earnings, sales, and EBITDA trends remain strong. Defaults are historically low, and significant private equity dry power remains on the sidelines to further stimulate the lending markets.
All of the structural changes that led to the emergence of non-bank lending as an established lending class are firmly in place. There’s a continued “slowing, but growing” macroeconomic outlook that supports the need for uncorrelated, income-focused assets. The loan universe is one place to look – with originated loans providing strong investor protections and non-levered returns, and the syndicate market offering greater size, broader diversification, and more liquidity. Utilizing a strategy that marries both markets may provide your fixed-income portfolio with the convexity it needs in this environment.