SACRS Fall Conference 2013

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1 SACRS Fall Conference 2013 Bank Loans November 14, 2013 Allan Martin, Partner

2 What Are Floating Rate Bank Loans? Senior secured floating rate debt: Current Typical Terms: Spread: LIBOR %-6.00% LIBOR Floor: 1.25%-1.50% Cash Yield: 6.25%-7.50% Collateral: All assets and stock of borrower Final Maturity: 5-7 years (average life <4 years) Contractual quarterly principal repayments Financial and non-financial covenants Borrowers are typically seasoned, healthy, growing companies, but have limited access to capital: U.S. smaller mid sized companies: < $500MM revenues or < $50MM EBITDA Europe large middle market companies: 100MM- 500MM EBITDA Europe small middle market companies: 10MM- 100MM EBITDA Typically cannot access high yield bond markets or other public capital markets Loans generally compare favorably to broadly syndicated loans: Use of Proceeds Fund Working Capital Needs Facilities Expansion Merger/Acquistion Buyouts, etc. Source: NEPC, LLC and S&P LCD 1

3 Floating Rate Loans Yields have a lot more room to move up vs. down Significant duration risk in typical Barclay s Capital Aggregate Portfolios Thoughtful, well-managed credit risk can be preferable to duration risk Two ways to access that we will discuss today Some similarities: Floating rates based on Libor Senior secured notes Replacing bank capital Bank Loans (ie ING) Liquid In general, larger companies Generally no leverage on the investment Profiling 5-7% returns Generally US/some European opportunities Middle market direct lending (ie White Oak) Illiquid with 2-5 year tenor Senior secured loans Mid-size companies May include leverage Profiling 7-12% returns based on strategy US/European/Asian 2

4 Assumption Setting in 2013 Capital Market Observations After broad rally in 2012, opportunistic trades are less compelling Most markets have recovered from pull back in 2011 Lack of good value across markets presents opportunity to revisit investment objectives and confirm long-term strategic allocations Global growth outlook remains constrained as developed world lacks political will to truly address debt burden Pressure for fiscal tightening (European austerity, US fiscal cliff) could neutralize benefits of monetary stimulus Structural debt issues plus ancillary effects of money printing will extend deleveraging Forward-looking expectations are lower after recent market rally Performance in credit and US equity markets lowers 5-7 year expectations across these asset categories Yields remain low as do sovereign bond return expectations Non-US equities have high risk but also higher return expectations 30-year returns also lower for credit markets Broad based credit spread compression and low sovereign yields reduce long-term expectations for credit Equity asset classes less affected by rally and supported by higher inflation expectation over 30 years 3

5 Starting Yields Signal Bond Returns Starting yield is the key building block for future performance Correlation to forward return of 0.88 Yields have had a 30-year secular decline This has been a tailwind to performance Low current yields will challenge forward looking returns 10 year Treasury Yield as of January 22, 2013 was 1.86% Source: St. Louis Fed, Ibbotson, Research Affiliates 4

6 NEPC 2013 General Actions for Public Funds Focus on strategic allocations in a time with few tactical opportunities Confirm your policy objectives and investment goals Avoid stretching for higher returns through increased risk Be prepared to act if opportunities do present themselves Position for a continuation of macro-driven themes Examine existing managers capabilities Add to global asset allocation and top-down active strategies Use flexible active managers to implement allocations to policy-driven markets Non-US equities have attractive valuations, but return premium reflects downside risk Credit markets have recovered but liquidity has fallen, making market dynamics less stable Use Risk Parity as a stable foundation of a diversified program Reconsider what constitutes a core investment in this environment No longer just stocks and bonds Risk Parity can be used as a liquid placeholder while tactical opportunities are limited Allocate to less liquid strategies with patience Distressed assets thesis is compelling but current opportunities are limited Strategies providing capital to markets that have traditionally relied on banks are appealing with high income and relatively shorter time horizons Significant system stress remains in real estate market but conditions have improved 5

7 Investment Approach: Benefits of Senior Secured Loans High current income: Returns predominately based on current income (coupon, fees and appreciation in warrants and stock) Reduces J-curve effect Several hundred basis points above alternative and traditional asset classes Senior secured: Senior loans are at the top of the capital structure with a senior-lien on assets and a pledge of company stock Lack of capital from previous sources has made lending structures more conservative and the asset class more appealing Lower default rates and higher recovery rates in lower-middle market senior secured loans Consistent returns: Performs well throughout various economic environments Structured as floating rate over LIBOR (with a floor) to protect and provide a hedge against rising interest rates S&P s middle market loan index, a proxy for senior secured direct loans, is largely uncorrelated with traditional asset classes Source: NEPC, LLC, Audax Group and S&P LCD 6

8 U.S. Middle Market: Lender Consolidation Since 2008, many middle market banks and finance companies have been acquired or have closed. Source: Audax Group 7

9 Shrinking European Loan Investor Base Source: Park Square Capital 8

10 Risk-adjusted Return Comparison of Credit Strategies 20.0% Target Return (Upside Potential) U.S. & European Senior Secured U.S. High Yield U.S. Investment Grade Corporate 10-Year Treasury Mezzanine S&P 500 HFRI Weighted Composite EMD Sovereign EMD Corporate 0.0% 0.0% 20.0% Perceived Risk (Volatility, Downside and Liquidity) Source: NEPC, LLC. For illustrative purposes only; actual performance may differ. 9

11 Executive Summary NEPC believes that the Senior Lending opportunities currently in the market across various global geographic regions possess attractive risk/reward characteristics This investment theme is based on the supply and demand imbalances that are apparent due to the gap left by the banking industry s move away from a capital provider to middle market companies The basic characteristics of the US senior lending opportunity are the following: A relative play that we would consider to be in the middle innings of its investment time horizon, however, we believe that this is still a value add alternative to the US fixed income market More susceptible to the impact of new entrants compared to the European and Asian market Time line for the investment is estimated at 2-4 years Main risk is related to the demand for financing being reduced due to adequate suppliers of capital in the market to meet demand 10

12 Portfolio Construction Scenarios 11

13 Portfolio Considerations Portfolio Construction Scenarios: Where does this belong in a portfolio and various approaches U.S. Only Europe Only Other Geographies Return Oriented Portfolio Dedicated Managers or Multi-Strategy/Multi-Geography Managers Access method: Originate Syndicates Secondary Bank regulatory Trades Frequently Asked Questions: U.S. Europe Asia 12

14 U.S. Middle Market Senior Secured Loans 13

15 U.S. Opportunity Overview: U.S. middle market senior secured loans may offer an attractive risk-adjusted return. A fundamental supply/demand imbalance in the U.S. market may continue. CLO issuance has begun to re-emerge, but still remains below levels capable of absorbing refinancing and new issues. Regulatory pressures remain and banks have decreased their exposure to leveraged lending. The demand for senior secured loans is expected to increase as private equity sponsors invest uncommitted capital. Source: NEPC, LLC. NEPC, LLC and The Newport Group are not affiliated. This is not an offer or solicitation to buy any fund or security mentioned in this presentation. An offer can only be made by a private placement memorandum, and this material describes the risks, charges and expenses related to an offer. Investors should carefully consider the investment objective, risks, expenses and charges before investing. 14

16 Current Yields 8.00% Market Rates and Yields as of 9/30/ % 6.97% 6.00% 5.00% 5.22% 5.32% 4.00% 3.25% 3.00% 2.34% 2.64% 2.00% 1.00% 0.249% 0.33% 0.00% US$ Libor (3-mo) US Treasury (2 yr) Barclays US Agg Index US Treasury (10 yr) US Prime Rate BoA Merrill Lynch High Yield Index S&P Broadly Syndicated Loans - Primary S&P Middle Market Loans - Primary Source: Audax Group and NEPC, LLC 15

17 Middle Market Higher Spreads Middle market loans have earned a premium over broadly syndicated loans. Spread differential at historically wide levels L+700 L+600 L+500 L+400 L+300 L+200 L+100 L+0 Middle Market Large Corporates Source: S&P LCD 16

18 Defaults and Recoveries: Middle Market versus Broadly Syndicated Loans Private Debt Markets: Better Principal Protection Lower-middle and middle market loans have historically demonstrated default rates that have been lower while recovery rates have been higher. 10.0% 8.0% Senior Loan Default Rates by Loan Size* 7.0% 8.6% 8.1% 7.5% 100.0% 80.0% Recovery Rate by Loan Class** 86.0% 81.0% 71.0% 6.0% 60.0% 52.0% 4.0% 4.1% 40.0% 2.0% 20.0% 0.0% Middle Market (<$100MM) $100 - $249MM $250 - $499MM $500MM or Greater All 0.0% Middle Market (<$200MM) Large Cap Loans (>$200MM) Senior Secured Bonds Senior Unsecured Bonds Source: S&P LCD. *Cumulative institutional loan default rates by deal size from 1995 to **Reflects ultimate recovery rates for period 1989 to

19 European Middle Market Senior Secured Loans 18

20 European Opportunity Overview: European middle market senior secured loans may offer an attractive risk adjusted return, particularly in the context of a low-growth economic environment. Fundamental supply/demand imbalance in European leveraged loan market may continue, supporting premium pricing relative to North America. Banks remain Europe s largest credit investors, but are under increasing regulatory pressure to shrink their balance sheets. CLOs, Europe s largest institutional source of credit, are in run-off with limited new formation. Growing importance of non-bank arrangers and anchor investors who can commit in large size. 19

21 Supply/Demand Imbalance: Lower Leverage & Higher Yields Source: Park Square Capital 20

22 Sources of Financing Europe has a less developed shadow banking system than the U.S. Source: European House-Ambrosetti, WSJ 21

23 Banks Retrenching Under Basel III Source: Park Square Capital 22

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