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For ideas about the opportunities for investors in private credit markets, Institutional Investor recently spoke with:
What is driving interest in the private credit market?
Roelke: Private credit investing has been a hallmark of TIAA’s investment program for decades. Given our firm’s long-term investment horizon, we are comfortable with less-liquid investments, like private credit, that provide offsetting benefits when compared to public market investments. Those benefits include yield premiums, diversification, and structural elements such as traditional financial covenants that help mitigate risks inherent in holding an illiquid investment through maturity. In today’s yield-constrained environment, we have seen a dramatic increase in investor demand for this asset class.
What are the different segments of the private credit markets?
Vichness: Private credit investments can be found across the credit spectrum from traditional, fixed-rate debt private placements, credit tenant loans, and infrastructure debt in the investment grade world, to senior and junior middle-market loans and mezzanine in the speculative grade category. Given the scale of TIAA’s platform, we have teams that specialize in each of these sectors.
Kencel: Churchill Asset Management is TIAA’s majority owned middle-market senior loan affiliate. We make loans to companies with up to $50 million of cash flow that are arranging senior credit facilities of up to $250 million in size. In our market, financing is provided by a small club of lenders that conduct primary due diligence on the borrowers and negotiate covenants and pricing. Given recent volatility in the public non-investment grade credit markets, we believe middle-market senior loans are a compelling proposition for institutional investors from a risk/reward perspective with a buy-and-hold orientation that drives a focus on deep fundamental analysis. We identify financing opportunities with private equity owned companies that are not yet large enough to access the more liquid broadly syndicated loan market. Our senior loan investments always have a first lien senior secured position in a company’s capital structure and traditional financial covenants, and we enjoy better pricing and lower leverage than broadly syndicated loans.
How has the middle-market senior loan landscape changed in recent years?
Kencel: After the global financial crisis, many of the large commercial banks that historically provided senior secured loans to middle markets companies exited middle-market direct lending to focus exclusively on underwriting and syndicating larger more liquid loans. This was in part driven by the increased capital requirements and regulatory burdens that made middle-market lending less economic for them. So the outcome is that today there are only a handful of firms, such as Churchill, that focus on traditional middle-market senior loans. That dynamic has resulted in more favorable terms and pricing and traditional covenants in these loans.
Where do you see the most appealing opportunities in today’s market?
Vichness: Investing in private middle-market senior loans can deliver consistent attractive yields in the 6 to 7 percent range each year without the inherent volatility of broadly syndicated loans, high-yield bonds and junior debt investments in the middle market.
What about liquidity?
Roelke: Private credit investments appeal to investors who have long-dated needs in their portfolios, such as insurance companies and defined-benefit (DB) and defined-contribution (DC) plans. That’s because these private credits are structured as “buy-and-hold” investments. Many institutional investors and plan sponsors are comfortable with the illiquidity in this asset class, because of their long-term horizons.
What about duration risk?
Kencel: Middle-market senior loans typically provide for a floating rate based on LIBOR, offering an element of protection against rising interest rates when compared to fixed-rate investments, like high-yield bonds. The majority of our loans tend to pay off in three to four years, further reducing interest rate risk.
Vichness: It’s also important to remember that middle-market senior lenders are generally like-minded investors who are committed to working closely with borrowers over the duration of a loan to resolve any potential problems directly with the company.
Are there other factors to consider?
Kencel: Generally, middle-market senior loans have lower leverage than broadly syndicated loans, high-yield bonds or junior subordinated debt. This has historically resulted in lower defaults and lower losses. The loan to value (LTV) ratio is typically 40 to 50 percent, reducing investment risk. It is also important for investors to look at the loan amount relative to a company’s historical EBITDA or cash flow. Our loans are typically funded at between three and four times historical cash flow in transactions where a private equity sponsor is acquiring a business for eight to ten times, providing a strong level of equity in our deals most often in excess of 40 percent. A loan ratio of three times earnings is safer than a loan of six times earnings.
Let’s look at the outlook for 2016. How will global market volatility affect middle-market senior loans in 2016?
Roelke: In general, the private credit markets do well in volatile times, unlike the public credit markets, which can see strong inflows and outflows, or the high-yield market, which can be open or closed at certain points. Because of their illiquid nature, and due to the downside protection afforded by financial covenants, private credit instruments can serve as a stabilizing force in investors’ portfolios.
How do you make credit investment decisions?
Kencel: At Churchill, we look at sectors that are not subject to commodity price changes, such as the dramatic drop in oil prices. The objective is a portfolio that consists of solid companies in non-cyclical industries that have demonstrated the ability to perform well throughout the economic cycle.
Do you look for deal volume?
Kencel: No. We are very selective. We conduct a thorough credit analysis and ensure the traditional loan covenants are in place. We underwrite these credits based on the low point in the cycle in keeping with our goals of principal protection and consistent yield. Because we plan to hold these loans through maturity, fundamental due diligence on the front end is critical. We are defined as much by the deals we don’t do as by the deals we do.
What are the differences between U.S. and European private credit?
Vichness: The private credit market in the U.S. is much larger than in Europe. We estimate up to five times the size. Moreover, in Europe, the banks are still quite active, limiting the opportunities for direct lenders.
Kencel: From a creditor’s perspective, the U.S. has clear and consistent rules for bankruptcy and reorganization, compared to Europe where the bankruptcy laws vary widely by country.
Any additional thoughts about this market opportunity?
Kencel: We are big believers in the opportunity for institutional investors today in traditional middle-market senior secured loans. Consolidation in the banking industry and increased regulation on capital requirements have significantly reduced the supply of traditional senior debt capital to the middle markets. This has resulted in a very attractive supply-demand dynamic in the middle market in favor of the lenders. It has generally driver lower leverage and better pricing in the middle market. With all-in yields consistently in the 6 to 7% range, we believe it provides excellent risk adjusted returns for institutional investors with long-term horizons.
TIAA Global Asset Management provides investment advice
and portfolio management services through Teachers Insurance and Annuity Association and affiliated registered investment advisors, including Teachers Advisors, Inc., TIAA-CREF Alternatives Advisors, LLC and Nuveen Securities, LLC, TIAA-CREF Individual & Institutional Services, LLC and Teachers Personal Investor Services, LLC. distribute securities products.
For more information:
Jennifer Pedigo (Americas): Jennifer.Pedigo@tiaa.org