We all know that interest rates are incredibly low. The three month Libor continues around 30 bps., an extremely low level designed to spur growth in the economy. Yet, other than asset-based loans priced at L+200 to 300, loans to middle-market companies continue to be expensive, and have not declined nearly in proportion to the decrease in overall interest rates. In fact, for many financings, the weighted average cost of capital is in the 8.0 – 9.0 percent range, rates much higher than would be expected compared to just about any index.
Add to this the fact that middle-market loan volume actually decreased substantially in the fourth quarter of 2011. As reported by S&P LCD, leverage loan volume declined from an average of $4.8 billion per quarter in the first half of 2011 to $3.0 million in the third quarter, and a mere $1.8 billion in the fourth quarter, a 40 percent decrease compared to the fourth quarter of 2010.
So in a low interest rate environment, and with loan demand substantially reduced, wouldn’t you expect that yields on middle-market loans will decline and leverage multiples will increase as lenders compete for credit?
Unfortunately, like most things in life, you need to peel back a few layers of that onion to see what’s really going on. And what you first discover is that while, again according to LCD, the number of institutional lenders has remained relatively constant between 2006 and 2011, hedge funds and prime-rate funds went from 30 percent of the total lending activity to 47 percent, a 50 percent increase (with most of that increase coming from the decline in CLO activity).
And when you peel back a few more layers, you discover that the providers of capital to these new institutional lenders have return expectations that are often more closely aligned to exceeding other alternative investments they are considering and much less influenced by the overall interest rate environment. For example, a BDC that doesn’t pay out a dividend of at least 8 percent is in jeopardy of losing its ability to raise additional equity. Likewise, hedge and credit opportunity funds normally promise their investors a net 8 percent return or fear losing them to higher-yielding competitors.
And peeling one more layer back, these current institutional lenders are unable to get the leverage that CLOs enjoyed back in the 2006 days. BDCs are restricted to 1 to 1 leverage, and hedge funds can rarely get more than 2 or 3 to 1 leverage today, a far cry from the 8 to1 leverage enjoyed by many CLOS during the boom times. As a result, these new lenders need to get their returns through interest rates from borrowers, not internal leveraging.
So despite the low interest rate environment, and the decrease in demand for capital, today’s lenders cannot accept yields lower than what they are currently receiving or they risk going out of business. Fortunately, these new institutional lenders are able to benefit from the continued lack of a robust senior cash flow market (which, interestingly, is largely due to the decline of CLOs) and their ability to provide alternative financing structures, like unitranche facilities.
Unitranche structures, which have become so pervasive in the last couple of years, both fill the capital void left by the departing cash flow lenders as well as enable these lenders to achieve the higher return expectations of their own investors. By providing unitranche structures priced around 10 percent all-in, even with modest leverage, lenders can pay their overhead and return the required minimum 8.0 percent return to their investors. And the recent layering of the unitranche, where the loan is internally divided in o two pieces with the first-out piece being taken by a senior lender, gives these providers even greater yields, while the borrower’s cost of capital stays within the 10 percent range.
Eventually things will change, and CLO formation will return (or market dynamics will shift, fostering a proliferation of alternative senior debt providers with lower costs of capital). But, until then, don’t expect yields to go down. These lenders are determined to stay in business and providing their own investors with the expected yield is how they need to do so. In fact, if loan demand increases, yields may actually go up.