Debt is such a commonly known concept for people living in the 21st century, yet it has a long history. Tracing back to Mesopotamia 2000 BCE, the first instances of lending and borrowing came from farmers who borrowed seeds and animals against a later payment.[1] Over thousands of years, the process of lending has grown into more creative and complicated forms. Today, debt is an important component in corporate capital structures. Debt facilitates better usage of cash and boosts higher corporate growths. However, after the 2008 great financial crisis (“GFC”), banks have gradually tightened the lending requirements for private businesses due to stricter regulations.[2] This has prevented many small companies from borrowing and therefore, prevented them from growing. As a result, a large amount of private businesses, with solid product lines and customer bases but weaker capital structures, were unable to access the debt capital market in the same way as before the GFC. For private capital providers, this has created substantial investment opportunities, which yield higher coupon[3] than public market debts. In this new way of investment, investors are offered returns ranging from 5% to 20%. However, for both borrowers and private lenders, “bigger is better” is not necessarily the end of the story.
In the last couple of years, the capital market has recovered. In December 2015, the Federal Reserve (“Fed”) raised the Federal Funds Rate (“Fed rate”) to create a stricter monetary policy[5]. This caused many debt securities to be issued before Fed rate hikes became less attractive, since the base rate now became higher.[6] More capital flowed away from traditional fixed income investment vehicles and piled into private capital market because investors wanted a higher yield and return.[7] Private direct lending is a “form of corporate debt provision in which lenders other than banks make loans to companies without intermediaries such as an investment bank, a broker or a private equity firm.”[8]
In the last two years, a number of private Business Development Companies (BDCs) were founded as private capital investment managers.[9] Private BDCs gather from Limited Partnerships [10] (i.e., endowment, pension fund, or family offices) and provide private lending to private businesses.[11] Private BDCs were very popular in the last two years. Firms like Owl Rock, Golub, and Apollo formed private credit investment vehicles, raised more than $5 billion cash commitments, and started to pile into the private lending space. Twin Brook Capital Partners, Angelo Gordon & Co’s mid-market direct lending subsidiary, along with a lender that lowered middle market companies,[12] have raised over $2 billion in a first close for the AG Direct Lending Fund III.[13] Twin Brook drew $2.3 billion in all of 2017 and $850 million in 2016.[14]
Large amounts of money have flowed, and continue to flow, into private lending space. What will be the results? First, covenant-lite loans will continue to dominate the U.S. credit market.[15] Covenant-lite loans are a type of lending that has less restrictive terms on the borrowers than traditional loans. Traditional loans generally have protective covenants built into the contract to protect the lender, such as financial maintenance tests that measure the debt-service capabilities of the borrower. Secondly, (and consequently) loan amounts will continue to grow larger, leading to increased risk of defaults. Third, as the Fed rate continues to increase, borrowers will continue to take advantage of fixed-rate coupons. Fourth, there is a problem with uni-tranche lenders. BDC uni-tranche debt is a type of structured debt that obtains funding from multiple participants with varying term structures.[16] This type of debt is typically used in institutional funding deals.[17] It allows the borrower to obtain funding from multiple parties, which can result in decreased costs from multiple issuances, provide for greater fundraising through a single deal process, and facilitate a faster acquisition in a buyout.[18] As a result of these new credit strategies, credit managers have a larger balance sheet of loans than ever before.[19] During a recession, the lenders will have to pull capital to make up for these once high-yielding loans on their balance sheets, and therefore tighten lending again, just like banks.[20]
[1] A Brief History of Lending, Bond Street: Small Business Blog, http://bondstreet.com/history-of-lending (last visited Nov. 8, 2018).
[2] Dan Wilchins and Emily Kaiser, U.S. Banks Tighten Lending Standards, N.Y. Times (Jan. 7, 2008), https://www.nytimes.com/2008/01/17/business/worldbusiness/17iht-lend.4.9295180.html.
[3] In very general terms, coupon is an annual or semi-annual interest payment paid out on bonds. The terms of coupon and coupon rate (in percentages) are generally interchangeable. For more detailed definitions, refer to Investopedia, https://www.investopedia.com/terms/c/couponbond.asp (last visited Nov. 20, 2018).
[4] Cambridge Associates, Research Publication, Private Credit Strategies: An Introduction (Sep. 2017), https://www.cambridgeassociates.com/research/private-credit-strategies-introduction.
[5] See Board of Governors of the Federal Reserve System: Policy Tools: Open Market Operations, for a history of fed rate hikes in the past couple years, https://www.federalreserve.gov/monetarypolicy/openmarket.htm.
[6] Simon Moore, A Bond Strategy For Rising Rates (Nov 15, 2017, 7:41AM), https://www.forbes.com/sites/simonmoore/2017/11/15/a-bond-strategy-for-rising-rates/#c9ca148524f5.
[7] Interview with Boyang Song, Portfolio Analyst at Turtle Creek Investment Advisers.
[8] See Direct Lending, Wikipedia, https://en.wikipedia.org/wiki/Direct_lending.
[9] For a complete list of BDCs, yields, prices, and market caps, see Full Business Development Company List, https://www.bdcinvestor.com/business-development-company-list. The highest yielding BDC on the list is THL Credit, Inc. (NASDAQ: TCRD).
[10] See Regulating Rollups: General Partners’ Fiduciary Obligations in Light of the Limited Partnership Rollup Reform Act of 1993, 47 Stan. L. Rev. 85, 87 (discussing limited partners benefiting of limited liabilities and preferential tax treatments from limited partnerships).
[11] Supra note 7, Interview with Song.
[12] This same lender had between $3 million and $50 million in EBITDA
[13] Leela Parker Deo, U.S. Middle Market Direct Lending Strategies Still Raking in Capital, Reuters Business News (Aug. 9, 2018, 3:45 PM), https://www.reuters.com/article/us-middlemarket-fundraising/u-s-middle-market-direct-lending-strategies-still-raking-in-capital-idUSKBN1KU2ES.
[14] Id.
[15] Tim Cross, Covenant-Lite Credits Continue To Dominate U.S. Leveraged Loan Market (Feb. 8, 2018, 5:18PM), https://www.forbes.com/sites/spleverage/2018/02/08/covenant-lite-credits-continue-to-dominate-u-s-leveraged-loan-market/#3522eeb94400 (noting that “Covenant-lite loans, an issuer-friendly feature that offer less protection for lenders and investors than traditionally structured credits, now account for a record 75% of the roughly $907 billion in outstanding U.S. leveraged loans).
[16] Uni-Tranche Debt, Investopedia, https://www.investopedia.com/terms/u/unitranchedebt.asp (last visited Nov. 9, 2018).
[17] Id.
[18] Id.
[19] Arleen Jacobius, Investors in Credit Industry See Danger Ahead, Pension & Investments (Aug. 20, 2018), https://www.pionline.com/article/20180820/PRINT/180829990/investors-in-credit-industry-see-danger-ahead (quoting Christopher J. Flynn, CEO of THL Credit Advisors LLC).
[20] See id.
