By Aaron Weinman and David Brooke
NEW YORK, Sept 24 (LPC) - Borrowers in the US loan market are looking to private placements over longer syndication processes as cash-rich private credit lenders gain more clout in the junior debt space.
Private credit funds are the biggest buyers of second-lien loans but have spent the last six months nursing their loan portfolios with urgent liquidity injections while the coronavirus pandemic stunted economic growth. As the US economy begins to reopen, however, direct lenders are lining up to take on significant slices of riskier debt, including second-lien loans.
These subordinated tranches of loans offer higher returns than first-lien facilities, but their recoveries could be wiped out in a default scenario. In exchange for the added risk, second-lien loans have offered an average three-year yield of about 9% this quarter, Refinitiv LPC data showed.
Private placements can be sold to a single investor or a small club of lenders. Unlike syndicated institutional loans, the terms of these transactions are usually hidden from the broader market and in many cases, are not available for trading in the secondary market.
Four companies privately placed approximately US$1.35bn in second-lien loans with direct lenders this month. September's tally alone is a sharp jump from the first half of 2020, when just US$2.4bn in second-lien facilities was placed privately, according to Refinitiv LPC data, underscoring investors' unwillingness to tackle riskier debt amid economic uncertainty. A further US$3.06bn in second-lien loans was raised in the syndicated market throughout the first half of the year.
"The capital raised to invest in direct lending is mind-boggling," said Gretchen Lam, a senior portfolio manager with Octagon Credit Investors. "At times, companies will now just syndicate their first-lien loans and find a buyer to take their second-lien debt privately."
A report from financial research firm Preqin found that direct lending funds had US$314bn in assets under management (AUM) at the end of 2019. Of the total AUM, funds are sitting on US$95bn in dry powder – capital ready to invest in transactions.
Higher education software provider Ellucian privately placed a US$540m second-lien loan this month, alongside a US$1.6bn first-lien effort to refinance debt and fund a dividend to its private equity owner TPG Capital, a banker familiar with the deal said. The transaction is the largest second-lien loan to be privately placed since medical services provider Sotera Health's US$770m deal was placed in November 2019, according to Refinitiv LPC data.
Banks, too, can offer borrowers the choice of a private placement with an individual fund or a club of lenders, obviating the need to syndicate a second-lien loan among a large group of investors.
"Sponsors often choose to take the second-lien syndication risk off the table by either signing a commitment with a bank (which) can quickly de-risk via a private placement or just signing the deal with a second-lien provider," said Chris Blum, the head of leveraged finance for North America at BNP Paribas.
In the aftermath of Covid-19, private investors amended their portfolio companies' existing loan facilities or provided incremental debt to withstand the economic slowdown brought on by the pandemic.
As funds turned inward, their average hold sizes on individual loans dipped compared with previous years, according to a survey conducted by Refinitiv LPC in June. Just 7.7% of direct lenders said they would hold a loan of US$200m or larger, less than half the 15.6% of respondents willing to go above this threshold in 2019.
That sentiment has started to change. As private investors renew their risk appetite, these lenders have also increased interest in holding larger loans in order to put their money to work.
"Large funds need to deploy capital, so direct lenders are taking on second-lien loans to drive up returns for their investors," said Kristopher Ring, a partner at law firm Goodwin Procter. "If it's a syndicated loan that's in a sector the fund has an appetite for, private credit firms will take down the second lien and hold it for a while."
While the number of second-lien private placements has increased this month, direct lenders have also spent the last six months funding sizeable add-on facilities to existing unitranche loans.
Earlier this month, Golub Capital led a US$430m incremental financing for MRI Software and a US$400m add-on loan for insurance brokerage firm Risk Strategies. The additional debt lifted both companies' unitranche loans above US$2bn.
MRI obtained US$250m from Golub and fellow private lenders Ares Management, Antares Capital and Crescent Capital Group, according to a source familiar with the deal. The rest of the loans were privately placed.
While new-money opportunities, including financing for mergers and acquisitions, remains thin, these incremental and second-lien loans, offer attractive returns for private funds. A traditional unitranche facility for a sponsor-backed company can price between 550bp to 700bp over Libor while a second-lien facility can generate returns above 800bp over Libor, according to data compiled by BDC Collateral.
"It's the evolution of the direct lending marketplace; you've got more sophisticated players coming in," said Todd Koretzky, a partner at law firm Allen & Overy that advises lenders on loans. "If you're creating a lending business or a platform for underwriting and distributing debt, it's powerful when you can offer sponsors both options – a private debt solution or syndicated loan." (Reporting by Aaron Weinman and David Brooke. Editing by Michelle Sierra and Kristen Haunss.)