Where's the Income?
Today's fixed-income market has gotten so lean, where's the income? With market interest rates at stunningly low levels, traditional fixed-income investments that are "fixed" from a safety point of view do not generate meaningful "income"—and those that offer "income" often come with so much risk that one can hardly call them "fixed."
In today's "fixed or income" investment climate, how can investors generate decent returns without taking outsized risk?
One answer: a prudent strategy of senior secured direct lending to profitable, medium-sized, privately owned companies. The attractive risk/return dynamics in this strategy come from structural factors like increased bank regulation and are expected to continue. Investors can participate in this strategy through publicly traded funds with favorable tax treatment, called business development companies (BDCs). A small number of BDCs specialize in middle market senior-secured debt.
The definitions of key terms in the phrase "middle market senior-secured debt" reveal important characteristics of the strategy. Looking at the first part, "middle market" companies are big enough to be relatively stable and predictable. However, they are too small to raise capital in the public markets, and their complex needs often require more flexible terms than most banks can offer in today's highly regulated environment. From an earnings perspective, there is no bright line, but a middle market business generates roughly $10 million to $50 million of EBITDA.
As for the second part, "senior-secured debt" usually has priority over a company's obligations to its other creditors. This priority provides valuable protection to a lender in a normal environment, although skilled middle market lenders know how to underwrite loans that are likely to be paid back even in downside cases. Taken together, these terms describe a strategy to make well-protected loans to resilient, high-quality companies with complex financing needs.
Who wins in this market?
The leading providers of middle market financing, particularly for sponsor-led transactions like leveraged buyouts, are specialists with finely tuned underwriting and execution capabilities and deep relationships. Middle market lending is not a commodity business, and price is not the only factor on which leading players compete. In addition, middle market lenders today benefit from a supply/demand balance for credit that tends to favor lenders. Demand from private equity sponsors is currently robust, and the concern about year-end tax increases is likely to further drive loan demand later this year. At the same time, the supply of corporate middle market lending remains constrained.
A number of leading players did not survive the financial crisis, local banks are more conservative and there have been few new entrants to the market. Other traditional sources of capital, such as regional banks, have reduced their exposure in the face of capital and regulatory uncertainty. These dynamics give lenders the ability to shape the pricing and terms of deals.
Savvy investors have taken notice that middle market loan spreads are high by historical standards, at a time when yields in the traditional fixed-income market are extraordinarily low—particularly for credit instruments perceived to have relatively little risk of principal loss. These rich spreads are not the result of simply adding interest-rate risk or credit risk.
Unlike a Treasury bond, for example, most middle market loans have features that mitigate interest-rate risk. A typical middle market loan has a variable coupon that follows the market, coupled with an interest-rate floor that provides protection from a low-rate environment. Middle market lenders can also mitigate investors' exposure to credit risk by financing only resilient, recession-tested companies; by demanding protective terms and tangible collateral; and by investing in deals where sponsors contribute significant equity. Lenders are therefore able to achieve a combination of yield and safety that is difficult to replicate in public debt markets, where the supply of credit is abundant relative to demand.
Investors can participate in middle market lending through a business development company. The BDC is a particular type of regulated investment company that seeks to generate income and capital appreciation through a portfolio of middle market loans and investments. Different BDCs target different mixes of risk and potential return, so it is important to understand the philosophy and track record of the BDC's investment manager. Investments in GBDC and other BDCs carry risks that should be considered carefully before making an investment decision.
In an environment of persistently low yields on traditional fixed-income investments, the shares of well-managed BDCs, with a high dividend yield and the potential for capital appreciation, may be an attractive alternative for income-oriented investors.
Lawrence E. Golub is CEO of Golub Capital.
Disclosure: Golub Capital BDC, Inc. is a business development company.