Private debt can seem homogenous. But it’s an asset class in which managers are defined and differentiated by complexity.
For example, in the context of performing (as opposed to distressed) debt, holders of the same class of loan (i.e. first lien, second lien etc) should expect to generate a broadly equivalent premium, right?
Here we break down what drives private debt return, explaining where skill is most needed and where the hardest work lies. Ultimately, the greatest complexity premium is available to the party expending the most time and effort.
Debt is, by its nature, the lending of money by one party to another in return for compensation, usually in the form of interest. The best a lender of money can ever get back is their principal, plus interest.
Ongoing management of loans does attract some complexity premium, particularly for more structured assets. A good way to think of it is building a premium in for the “fuss factor” of managing the loans. However, ongoing management does not create value in the same way as, say, management of private equity. In private equity, development of a portfolio company continues throughout the life of the investment, through skills like turnaround expertise, or incubation oversight among many others.
For loans, a significant amount of the complexity premium is “front-ended”. It can come from the structuring and execution of the loan in the form of an upfront fee, comprising a smaller portion in the margin (the remainder of the margin comprising risk and market premia).
Complexity premium is elevated where significant skills are needed to source, select, structure and execute a loan. Being able to assess risk and price is a key fundamental skill. It includes understanding the industry and commercial drivers of cashflows or asset realisation, or both where both are important.
There are a number of ways to access loans, and drivers of complexity vary depending on the route taken. The two main ways though, are direct lending and via the broadly syndicated loan markets.
Complexity premium in direct lending
Direct lenders are lenders that originate and hold the loans they write.
Sourcing and structuring loans takes time, much longer than the time it takes to participate in a broadly syndicated loan. Indeed, it takes a similar amount of time to originate a direct loan as to originate a loan for distribution in the broadly syndicated loan (BSL) markets.
The strike rate (or success rate) of direct lending is relatively low compared to participation in BSL markets – albeit generally with high spread as a consequence - as it takes significantly more time to find the right deal you want to do, and then execute it. This is particularly so in acquisition finance where the asset being financed may be in “competitive play”.
Competitive play occurs when an asset is being traded or bid on in a competitive tender, and finance parties may be supporting different bidders. Arguably, competition puts pressure on lenders to maximise the return. In the BSL market, the deal is already agreed and won, hence competitive play is removed from the equation.
As a lender, your ability to execute is directly related to how aggressive your bidder or sponsor is. In many cases this is a function of how much leverage the asset can withstand, or you are willing to allow it to withstand.
The balance must be struck carefully to ensure the risk and reward works for all parties. Better to lose the auction, than win with an overly aggressive bid and lose your capital.
Broadly syndicated loan markets
In broadly syndicated loan markets the key characters are grouped into three broad categories:
- Borrowers (and their advisers)
You can originate and structure a loan. Then either sell it - known as underwriting and distributing - or hold it - “take and hold”. Or perhaps a combination of both.
The originator of the opportunity has assessed risk and structured the loan based on any factors that could impact the ability to recover principal and interest. If underwriting, the originator has taken a view on loan market size and capacity and then sold down the loan in smaller parcels or packages to ultimate participants.
The participant has taken the packaged loan and information, assessed whether it meets their risk appetite based upon the price offered, and then subscribed for an allocation.
Underwriters are paid for the time and energy put in to creating an outcome for both the borrower, and the ultimate lending group is paid for the risk taken on their balance sheets. This can be a combination of credit risk, market risk, industry risk and illiquidity and complexity premia, however they co-exist.
Why does a borrower use an underwriter?
Borrowers value dealing with one, or a smaller number, of financiers. This is why we refer to an appropriate “outcome” as opposed to just a loan. For the borrower, paying for finance is one thing, but borrowers will pay more - a complexity premium - for a more streamlined process. It is more than just convenience, it may mean less time and effort expended on one part of their capital structure.
The underwriters are paid for the risk in the form of underwriting fees, and margin on the loan if they hold the loans while drawn (a funded underwrite). The underwriters take (or “skim”) a portion of the underwriting fees, and pass on a smaller percentage (the upfront fee, or participation fee) to the ultimate lenders, who receive margin and other fees on their allocation from the time the risk is transferred to them.
The complexity premium for an underwriter is simply the value of the skim available to them for a successful syndication, i.e. fees received less fees paid away. In a competitive situation, the underwriter may expend significant work for an unsuccessful outcome. A deal won should also arguably compensate them for previous work on unsuccessful bids.
What specialist skills do participants need?
So, why might two holders of loans in the same class of a broadly syndicated loan not receive the same return? The answer is whether you are an underwriter who retains a hold, in which case your complexity premium takes into account the syndication risk you have borne (and as outlined above, the deals you may have lost). The complexity premium for participants on the other hand, is by its very nature less than that, given the opportunity has a much higher degree of certainty of putting money to work - but it still exists.
For participants a number of factors that relate to the holding and management of the loan instrument deliver return over and above the risk premium.
In particular, this takes into account what happens when things go wrong, and here is where the crossover with the illiquidity premium comes in. When assessing the loan, the lender looks at the likelihood of default, the structural remedies available to lenders in the event of default, and whether the margin is sufficient to compensate them for that risk. Also, importantly, they need to assess the risk taken relative to the effort likely to be expended in recovering capital in the event of default.
Market liquidity is relevant in this last point, as if a business is beginning to show signs of stress, some private loan markets do have deep and liquid secondary markets where participants can trade loans, particularly those in distress. In short, if a participant can “dump and run” if things start to go awry, they will likely expect less complexity premium in return.
In markets that are highly illiquid, such as the Australian loan markets, the illiquidity premium becomes more relevant. Complexity emerges more in (admittedly rare) distress, as there are often very few choices lenders have other than to roll up their sleeves and get involved in a workout process.
Time, energy and experience
Ultimately, no matter which private asset you look at, it is the value of time, energy and experience expended on a successful opportunity that delivers the complexity premium. While complexity premium – achieved over and above the illiquidity premium - can be best captured by direct lending and by underwriters, investors in BSL can capture different levels of complexity premium depending on the sector, structure and geography they participate in.