leverage is too high, sponsors may not be as patient as they otherwise might be during a market correction. A high LTV ratio, on the other hand, may be evidence that the GPs’ underwriting standards are too lax, and they are willing to take unnecessary risks to boost returns.
The gross asset yield of an investment considers both the coupon and the closing fees paid by the borrower to the lenders. Though co-investors are typically entitled to receive the closing fee, they should be mindful of “skimming” – the practice of shaving one or two points off the Original Issue Discount (OID). This skim is similar to the origination fee banks charge for bearing the risk that syndication implies.
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)
