Many of you may not know it's conference season, where guys like me get flown to exotic places listening to firms this forum salivates over (BX, KKR, Oaktree, PIMCO, GSAM, etc.) pitch investment ideas to us and blow tons of money to try to earn our business. It's both a nice escape from the office and a great learning opportunity.
The point of this thread is to ask experienced guys (particularly in FI) if one of the major themes I'm hearing has legs. Been hearing a lot about the banks' movement away from credit markets and alternative lendors stepping in. particularly in RMBS, CMBS, MM lending, and structured finance. On top of that, banks are looking to still offload financial crisis era loans from their balance sheets to comply with basel 3 and other regulations.
as a result of this, firms like the ones I've mentioned have stepped in as an alternative to banks. they have their own credit analysts, they know fixed income, and lending is fixed income, so why doesn't it make sense? of course, this does not mean that Oaktree is going to open a mortgage brokerage, but what it does mean is that Oaktree may go into partnership with Quicken Loans, ABC Mortgage, etc., give them underwriting standards (banks are not very lenient on res lending today), securitize the loans, and earn much higher returns than a standard 30y fixed from Wells Fargo.
there are similar gaps in willing lenders in middle market businesses, CMBS, and so on. there hasn't been much of a gap in high quality traditional borrowers looking for a mortgage or companies like Coca Cola looking for money (they can access capital markets), but for a hardware store franchise or a supplier of components to qualcomm that may have a ton of upside but just isn't the market cap needed to issue bonds, they need to go somewhere. without the banks, then who?
my question is this: you bond guys out there, is this really an opportunity? or is it smoke & mirrors? it seems to me like the opportunity is legit and if people who know credit inside and out are making the loans, it's not like in The Big Short where people are lending to strippers with 6 condos all on 5/1 ARMs. I don't get the sense that this lending market is being driven off of greed, moreso off of a supply/demand mismatch due to onerous regulations.
sidebar: for students/interns, look into credit. if this blows up, it could be incredibly lucrative. also, very few people in your generation look at being a credit analyst, long/short hedge funds are so much sexier, but I will tell you from experience that the best people to listen to are often the bond guys, and god knows Bill Gross and Jeff Gundlach have made tons of money being in the upper half of the capital structure.
@Bondarb" @Lizard Brain" @coreytrevor" @Eddie Braverman" @DickFuld" I bet you'll all have some insight, everyone feel free to comment, legitimately curious if this will be a big sea change in the industry.
I can't speak to the structured product side of things, but it's definitely a theme in middle market/direct lending. The interagency guidance on leveraged lending was release in 2013, and while it took a while for rules to be adopted, it has certainly influenced banks' behavior over the last year or two. Under the guidance, banks cannot easily underwrite or arrange debt for highly-levered LBOs (above 6x Debt / EBITDA). As a result, a lot of this activity has been pushed into the non-bank space. The big LBOs will still need traditional banking relationships due to the size of the balance sheet, but lots of alternative lenders have been stepping up big in the middle market space, and you see certain firms, such as Golub & Ares punching up-market on some financings.
Personally, I don't think that this activity will be returning to banks anytime soon, and there does seem to be a lot of opportunity in middle market credit at some of these shops.
Thanks for the insight. Is most of the growth you're seeing to mm companies or are you seeing growth in commercial and residential real estate lending as well?
I definitely agree with the above post, I also work in the middle market. Bank regulators seems to only care about leverage ratio and less about the business and strategic growth opportunities from the financing. Non-bank lenders are great for providing cov lite loans behind senior bank debt. Granted, you will always pay for the flexible terms.
When it comes to middle market lending, the non bank lenders have taken an increasing share of market for leveraged transactions. now the banks are left with more of the cream of the crop safer lower leverage companies with higher returns due to a high proportion of cash management relative to lending, seems like a good deal for banks. Banks can do just the cash manangement for companies financed by alternative lenders - even better. It's only bad for those irrationally focused only on commercial loan growth.
We have been experiencing some tighter lending standards for traditional lenders on our deals in the MM/Lower MM. The risk appetite of some of the regional/national bank lenders seems to be very low leading us to resort to alternative financing structures lately or going through a very tedious negotiating process on seemingly stable LBO type transactions.
This is for MM Direct Lending - I'd say it's not a bad trade particularly if you want to compare to 3-5 year IG credit since you'll get similar yields (or more) and be higher up in the cap structure so in the event of default you can still get recoveries hopefully in the 60+ range. I'd say the most plain vanilla is to target $15-40 MM EBITDA companies and get unlevered yields of L+4-7. But then you have guys putting a couple of turns of leverage or getting creative by doing smaller companies, adding leverage/warrants/mezz/equity which could alter your all in to 8-10+ IRR. So you could get something as straightforward as L+5 senior secured debt all the way down to mezz at L+12 and up. Very different return/risk profiles.
All to say it's a very fragmented space, and you really have to underwrite the quality of the manager, how they are incentivized for taking risk, whether you see eye to eye on strategy, the sectors they invest in (think energy these past two years), their capabilities in litigation and PE to take the keys in case of default. I think it's hard to find someone who is perfectly aligned with you as an investor. On top of that, this space is highly dependent on deal sourcing (some selection/availability bias in your manager's deals) and most lenders have gotten into the space post 09, so they haven't really had to deal with a bad credit environment so everyone's default and recovery rates are ridiculously good. Also when you are lending at higher rates, they want to refi out as soon as possible so your multiple isn't going to be high when you're deploying capital.
I think it's going to stay - people need access to credit to grow. When a business is doing well they will be willing to pay more for debt if that can help them grow without diluting equity. In the more plain vanilla deals I think they really are just replacing the banks and there's been some pricing power as a lender and the opportunity for investors to get pure income with protection. But not everyone in the space does just that and often for a manager it's not worth it to run a business at L+5 so they have to get creative with it which is where the true risk lies. So I'd take a very close look at what each manager is offering and which risks you're comfortable with taking and then whether the return is worth the risk. I don't think it will blow up like mortgages did, but I think it's entirely possible for a couple of these guys who are levered or playing in mezz to have huge losses, though because it truly is a fragmented market, you could do just fine regardless if you bet on the right horse. Also that means you have much less diversification relative to a bank or traditional bond portfolio.
Given hindsight, I'd say that your best bet was to take this trade on in its nascent years back in 09/10. To enter in now could be attractive depending on what you are comparing this to, but the space has blown up. There are those that are here to earn a quick buck which is slightly akin to the hedge fund boom - on the flip side of your argument that Oaktree could do this, all you have to do is put together a bunch of bankers/credit guys, take someone else's money and lend to somewhat desperate companies...
On the RMBS/CMBS/CLO side of things, yes, I think it's still a viable space and everyone's learned their lesson on mortgages (for now at least), so I don't think you'll see managers doing robo-underwriting and having low credit quality standards so the pools aren't going to be as risky. But I think the best way to take advantage is to buy from a relative value perspective after issuance or hold the equity piece alongside the manager. Also I think these bets speak more to overall macro economy/real estate since they are much more diversified sets of loans and securitized (versus middle market direct lending).
TL;DR: Fragmented space that is here to stay, success is highly dependent on manager selection, could be attractive depending on what you want to get out of it.
this is great. and agree on prime time of entry, there was 3x the IRR on similar vintages from 09/10, but on a relative basis, I'll take 10-15% net IRR in a low interest rate environment especially if the credit quality is better than the stated rate would dictate.
this really helped me, because in my simple mind, there's no free lunch, you either have higher yield because rates are high (they're not), or because quality is low. I suppose the argument of companies not wanting to dilute equity makes sense on why they're willing to pay above market rates.
thanks again bro, +1
Be careful on the 10-15 though... I haven't seen much evidence that you could get that in this environment without really reaching...
what does these mean for BB market markets in FI? Could prop trading return? http://www.wallstreetoasis.com/forums/republican-landslide-the-volcker-…
Would you classify Asset Finance as alternative credit? Large banks are currently making loads of profits through lease structures with a wide range of assets like cars, airplanes, energy assets or IT equipment but non-banks are starting doing this like Napier Park or Crayhill. Do you think this trend will continue?
The alternative lenders i look at (names above plus Ares) didn't mention specifically, doesn't mean it's not out there
Also thanks all, this has been really helpful
I would probably also take a look at 3i DM
I work for a lower-MM direct lending firm ("private debt/credit") focused on non-sponsored term loans with $1B+ AUM across a handful of funds. Industry agnostic, all types of transactions (e.g. growth capital, refinance, LBO/acquisition finance, dividend recaps, special sits, etc.). All in all it's a highly-competitive space as BDC's and SBIC funds are able to fairly easily source capital and banks are continuing to cut their appetite for risk. There are new MM direct lending funds popping up every month that can get 2/1 SBIC leverage (i.e. raise $50MM of commitments + borrow $100MM from SBA = $150MM to invest - sure you're borrowing for the SBIC loan but as long as you're lending at a higher rate you keep the spread). Credit/risk-taking makes the world go round and there are plenty of lower-MM companies who need financing for whatever purpose. Whether they merit said financing is another matter, and that's where the underwriting process/quality comes into play. I think there's something to be said for an investment that yields 9-10% returns with (nominally) full downside protection, assuming your principal amount is inside the asset value. Funds like mine prosper in times of volatility due to larger banks' absence, and I'd be lying if I said some of us here aren't hoping for a bit of a correction in the credit markets. All that does is drive potential borrowers into our open arms. Further detail below for those that are interested...
High-level terms of our deals are senior/junior secured (i.e. first/second lien on all assets and sometimes an equity pledge) at L+8-10 and up (cash and PIK) generally for companies doing $3-15M+ in EBITDA. Companies with higher EBITDA can usually get lower rates that generate IRRs below our hurdle unless there's a major issue with the company/transaction. Firms' like mine value prop is that we're willing to underwrite the hairy deals that down-the-fairway banks/lenders won't (and often can't due to regulation) touch. Principal amortization varies with the company's cash-flow profile and given the competitiveness in the market is often limited to Excess CF Sweeps and the like. We'll lend at ~3-4x senior leverage max generally for cash-flow deals but will also lend against the assets of a company without significant historical cash flow - for these types of deals we'll get double-digit interest, composed of cash and PIK, and usually some warrants to juice the returns and compensate us for the risk. We'll look at mezz and equity co-invest opportunities as well but only in our 'core' industries and hold size will be substantially smaller.
All of our deals have fairly tight covenants and the majority of our companies will trip said covenants at one point or another, as is life in the lower-MM working with highly vulnerable borrowers. If shit really hits the fan then we'll take over the equity of the company, hence the reason for the equity pledge mentioned above, and do with it as we see fit. Doing so brings you into a realm that I'd imagine is similar to distressed PE. This can result in anything from launching a sale process to recover our principal and acc. interest to doing a full-on restructuring/workout (out of court is preferred) of the company. The ultimate last resort is liquidation (Ch. 7 Bankruptcy) - a route that no one wants to take. It's interesting b/c for the easy credits/performing companies you can sit back, collect interest, and receive your principal (plus a healthy prepayment fee) without much involvement when they inevitably refinance you out with cheaper money. The fuck-ups in the portfolio command a much more hands-on approach obviously that may have you in contact with the company every day. Personally I'm very interested in the distressed/restructuring space although it can be stressful and morally taxing (i.e. it's not easy being the guy firing hard-working employees). But with the right underwriting standards, operating strategy/advisors, legal documentation, and a little bit of luck, you can generate massive returns and leave a company better off for the future.
Underwriting process is extremely hands on - building/tweaking/stress-testing operating models, multiple mgmt meetings, internal industry research, consultant/3rd party research, competitor due diligence, legal documentation (I have a ton of respect for lawyers who're able to make sense of all that legal mumbo-jumbo), etc. - anything and everything to formulate, support and finalize your investment thesis. Very similar to PE in that regard but despite the intensive due diligence process, at the end of the day it's credit investing with a flat payoff profile. The equity payoff structure resembles a long call option (unlimited upside) while credit is a short put (most you're getting back is the principal and some interest regardless of the underlying company's EV) if that helps you visualize it better. Equity wants growth, and while it's obviously good for everyone involved we could care less about growth. We want stability and ultimately for the company to pay us back our money, which I'd imagine results in a much different investor-company relationship than PE where the sponsor and management's interests are more closely aligned. This isn't always the case but we're inherently more distrusting/pessimistic towards the company and are constantly asking 1) what can go wrong and 2) how do I get paid back in that scenario? For that matter alone we try to stay 2-3 steps ahead of our borrowers in forecasting potential covenant trips, defaults, liquidity issues, etc. And when they do fuck up you can bet that we'll negotiate some more favorable legal terms for ourselves, which is one reason behind setting covenants tight in the first place.
Hope this sheds some light into a space that is growing at a serious clip and shows no signs of slowing down.
Alternative Lenders Up, Banks Down (Originally Posted: 08/28/2017)
Not necessarily a new topic, but interesting update from CrediFi.
https://www.credifi.com/credifi-analysis-alternative-lenders-banks/
Alternative lenders: Share your views, tell us whether you are seeing yourselves grabbing business from traditional lenders and where in the cap stack you are playing (e.g. first mortgage, mezz pref equity).
Wanted to add that saxxyman above hit the nail right on the head. Didn't see his post originally.
Would like to hear from some alternative lenders too
Where we have seen most alternative lenders winning deals recently is on leverage and sponsorship sensitivity to recourse, particularity on construction heavy projects. Another space we have seen them taking deals is when the capital stack involves some sort of non-sponsor equity such as tax credits. Banks dont like their sponsors not having real skin in the game and even if that weren't so, they aren't willing to go through the brain damage to understand/structure tax credits....can't much blame them though when they are getting paid 300-500 bps inside alternative bridge lenders.
Sponsorship seems to be very binary right now....they either have access to plenty of equity and can find it cheap enough to lever down and achieve bank pricing (and probably are willing to off recourse/guarantees).....or they dont want to put a single dollar in the deal so they use tax credits and high-octane debt to get them where they need to be. We have had a few situations where a larger balance sheet was brought in as pref in order to sign recourse and/or increase 1st mortgage debt.
All the above is obviously slanted towards ground-up/renovations/re-positionings, not towards stabilized deals. CMBS/Banks/Life Co seem to still be dominating that market and that wont be changing anytime soon.
To note, most of our work is regional and with non-institutional profile clients. My perception is that once you get to an institutional level, sponsors have so much access to equity they almost have to go the traditional route just to put it all out ....even if they dont, larger institutional lenders will basically buy the business one way or another to get a top notch sponsor....would love to hear the opinion of someone in that space, though.
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