Corporate lending was traditionally the business of commercial banks, but the global financial crisis and ensuing regulatory backlash created an opportunity for nonbank private asset managers to replace bankers as primary lenders to a large swath of middle market businesses, primarily in the United States. The economic recovery, albeit slow, found many middle market companies looking for debt capital for growth or refinancing. With banks in retrenchment, these companies found asset managers to be willing lenders. Lacking the deposit capital available to banks, the new direct lenders in turn have sought capital from institutional investors hungry for yields closer to 10% than the 1–3% available from traditional sources. Though estimates vary, the size of the corporate direct loan market in the United States today is perhaps as high as $400 billion and growing.
This book is directed primarily toward investors interested in learning more about corporate direct lending. The author comes from the perspective of an investment consultant to institutional investors providing research and advice on asset classes, manager selection, and asset allocation. The book therefore follows the same path that fiduciaries to institutional capital walk in their own due diligence on a new asset class.
Chapters 1–6 collectively describe US middle market corporate direct lending, addressing the three characteristics that broadly define any asset class: return, risk, and liquidity. Private debt, including middle market corporate loans, has long been a mystery to investors for lack of credible historical data. The findings in this book would not be possible without a research effort launched several years ago to construct a database and index for direct middle market corporate loans and published in a major investment journal.1 That research covering return and risk is updated along with a new chapter addressing liquidity.
Chapters 7 and 8 take a detour of sorts. Chapter 7 argues that fixed income as an asset class is more appropriately divided into two separate asset classes: an interest rate (Treasuries) asset class and a credit asset class. Instead of stock and fixed income allocations, investors should think in terms of three asset classes: stock, credit, and Treasury bond allocations. Chapter 8 provides a theoretical foundation for the three‐asset view by splitting fixed income into separate credit and interest rate components using option pricing models developed almost 50 years ago by Robert Merton, Fischer Black, and Stephen Cox. Their concept that any credit instrument can be modeled as a risk‐free rate plus a put option forms the basis for sensitivity analysis and simulation to better understand the behavior of yield, return, and risk for various types direct corporate loans and the value of covenants.
Chapter 8 is particularly useful in setting up Chapters 9 and 10. Investors who first look at direct lending are surprised by, and suspicious of, their higher yields. Chapter 9 provides an explanation for the high yields in direct loans by dissecting them into six components, each associated with a distinct risk factor potentially found in loans, and each offering an extra yield, or risk premium, as compensation for the specific risk factor. This yield architecture provides investors with a method for understanding and comparing absolute yields.
Chapter 10 takes a closer look at covenants, a real concern in today's environment as covenants are being stripped from new loans in covenant‐lite deals. The theoretical presentation in Chapter 8 includes an application of the Black–Cox Model that gives a formulation for measuring the opportunity cost of covenant‐lite in yield‐equivalent units. Under one set of assumptions, for example, the Black–Cox model values a covenant package as being worth 1% in yield. Chapter 10 provides an inventory of what comprises a typical loan agreement, including the elements of a full covenant package. Its purpose is to provide the reader a practical knowledge of the types of covenants in a loan agreement that are covered from a theoretical perspective in Chapter 8.
Investments that go terribly wrong generally have too much leverage or involve fraud. Many investors in direct corporate loans apply some leverage to enhance return. Chapter 11 examines the impact of leverage on portfolio return and risk and provides guidance to investors on what leverage level might be appropriate. Unlike traditional stock or bond portfolios where return and risk characteristics are similar among managers, direct lending offers investors many options that can materially differentiate one portfolio from another.
Chapters 12–17 discuss alternative forms for investing in direct corporate loans and some of the practicalities. Business development companies (BDCs) are covered first because they are the most visible of direct lending vehicles. Other topics include manager selection, loan valuation, fees, and portfolio construction.
Having covered what direct lending portfolios might look like and how they work, Chapters 18 and 19 together show how institutional investors can use the data and findings covered in earlier chapters to validate long‐term allocations to direct corporate loans within existing diversified portfolios using standard asset allocation technology. Chapter 19 provides examples of optimized portfolios showing that allocations to direct lending, both unlevered and levered, enhance risk‐adjusted return.
The research focus contained in this book is on direct corporate lending in the US middle market. But the same financial events that created the direct lending market in the United States also occurred in Europe, though to different degrees. Chapter 20 provides an overview of the direct lending market in Europe with comparisons to the US market. Unlike Europe, direct lending in Asia is in its early development stages.
Chapters 1 to 20 examine corporate direct lending from the investor perspective. Chapter 21 gives the borrower's perspective. A frequent question is whether the growth in the direct lending market will become stunted by the reversal in bank regulation under the current administration. Results from a survey of private equity sponsors suggest that borrowers are unlikely to reverse course and again rely upon bank lending.
The book concludes with a view of direct corporate lending as part of a larger private debt market. Direct lending should be viewed as a core component with breadth of opportunity and characteristics that should make investors comfortable with it as a long‐term investment. Other private debt investments tend to be smaller in market size and might be viewed as core‐plus or specialty, with higher return potential but higher risk. Chapter 22 provides short descriptions of 11 types of private debt outside direct lending that might be considered as complementary investments to a dedicated private debt allocation.
Together these chapters hopefully provide the reader with a strong foundation to further explore the investment opportunities in corporate direct lending.