Banks leave the door open for private debt

| December 4, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Investors have watched available yield drop now for the better part of nine months. Fed policy, prospects for pandemic recovery and fiscal stimulus have all reshaped rates and taken risk spreads tighter. At the same time, banks have tightened lending standards and arguably left creditworthy borrowers available to other private lenders. The ebb in bank lending and its likely return as pandemic lifts has potential to make private debt a timely source of yield and a strong performer over the next few years.

A loose collection of lending outside of banks

Private debt has emerged as a loose asset class in the decade since the 2008 financial crisis as regulation and banks’ own risk appetites have moved the boundaries of where banks willingly lend. Businesses with unusual cash flows, limited collateral, elevated debt-to-income, concentrated customer exposures or shorter operating histories have all found bank credit harder to come by. Broad economic weakness or narrow weaknesses in particular industries raise the bar further. Banks in 2020 tightened lending standards across almost all asset classes, opening the door for the second time since 2008 to private lenders and private debt (Exhibit 1).

Exhibit 1: Banks have tightened lending sharply in 2020

Source: Federal Reserve Senior Loan Officer Opinion Survey, Amherst Pierpont Securities.

Private debt has taken a wide range of forms but falls broadly into direct lending and the financing of direct lending. Direct lending loosely includes senior loans to mid-market companies, real estate loans, infrastructure debt, mezzanine or other subordinated debt, special situations, distressed debt, venture debt and occasional consumer debt. Financing of direct lending involves lending to owners of private debt portfolios, usually collateralized by the debt portfolio itself. The wide range of lending that falls under a private debt umbrella makes volumes hard to reliably estimate. But volumes in both direct lending and in the financing of direct lending are likely to rise as long as banks maintain current tight standards.

Rough indications of yield, return and diversification

For investors trying to get their arms around the potential portfolio role of private debt, the market offers little by way of return track records. But Cliffwater, LLC, has built a Direct Lending Index that tracks the publicly reported gross, unlevered returns on private mid-market corporate loans held by business development companies. That index shows a history of returns dominated by high and steady annual income, averaging 11% since 2004 with a standard deviation of 1.21% (Exhibit 2). Total returns are lower and much more volatile, averaging 9.4% since 2004 with a standard deviation of 7.44%. As a benchmark, the Bloomberg Barclays High Yield Index has delivered a compounded annual total return over the same period of 6.69% while the S&P/LSTA Leveraged Loan Index has delivered 4.28%. The Cliffwater index returns likely reflect the premium for lending to smaller, more leveraged companies as well as the premium for giving up substantial liquidity in private debt.

Exhibit 2: Income dominates returns to private lending to mid-market companies

Source: Cliffwater, LLC, all rights reserved, Bloomberg, Amherst Pierpont Securities.

The financing of private debt is probably a more practical way for most institutional investors to get exposure to this asset class. Among other things, it avoids the operating complexity of sourcing and underwriting direct loans. The investor instead makes a structured loan secured by a portfolio of private debt: mid-market corporate loans, single-family rental properties, business equipment loans or leases, subprime auto loans or similar instruments. Financing also has features familiar to investors in structured products. Among others:

  • Sizable transactions ranging from $50 million to $150 million or more
  • Unitranche structures that can combine the equivalent of different classes of senior, mezzanine or subordinated risk into a single loan or security
  • The ability to get treatment as a loan or a security
  • The ability to get structured as a term loan, a delayed draw term loan, a variable funding note or other forms
  • Asset quality tests and triggers, and
  • Often 50 bp to as much as 150 bp more yield than similar 144 structures with comparable attachment points

Returns from financing private debt should fit somewhere between those available to direct private lenders and those available in public and private securities markets. For investors that understand the underlying portfolio of private debt and can tolerate the sale of liquidity in a bespoke transaction, this niche could play a useful role in a market that has slowly whittled away other sources of income.

Performance of private debt through a bank lending cycle

The pattern of bank lending that has opened the door this year to private debt also stands to help boost returns on private debt over the next few years. Next year should bring substantial rebound from pandemic, which on its own would help the balance sheets of borrowers turning to private lenders now. But as the economy rebounds, banks, if history holds, will ease lending standards and come back into the same markets abandoned in 2020. Private loans made today could get refinanced at least partially into bank loans as recovery matures, strengthening credit, tightening spreads and raising value.

* * *

The view in rates

The Treasury yield curve has moved to its steepest level of the year in recent days as 2s10s hit 82 bp and 5s30s hit 132 bp. Prospects of fiscal stimulus, pandemic recovery through 2021 and a very easy Fed all should fuel further steepening. The spread between 10-year notes and TIPS suggests the steepening reflects rising expectations for inflation. Real yields have dropped in recent sessions with breakeven inflation rising to its highest level of the year at 192 bp. Implied interest rate volatility remains low, helped by high levels of market liquidity and a Fed likely to keep rates low and QE running through 2021.

The view in spreads

Fiscal stimulus, pandemic recovery and Fed policy also promise to keep spreads steadily tighter through 2021. Weaker credits should outperform stronger credits, with high yield topping investment grade debt and both topping safe assets such as agency MBS and Treasury debt.

The view in credit

Credit in the next few months could see some volatility if Covid begins forcing shutdown of some economic activity ahead of distribution of vaccines. But distribution and vaccine uptake through next year should put a floor on fundamental risk with businesses and households most affected by pandemic—personal services, restaurants, leisure and entertainment, travel and hotels—bouncing back the most.

john.killian@santander.us 1 (646) 776-7714

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