Private Placement Investing: the search for yield

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1 Portfolio Perspectives Private Placement Investing: the search for yield Private placement bonds allow fixed income investors the potential to expand their opportunity set and consistently improve their total returns. Relative to public corporate and municipal bonds, private placement bonds offer: Covenants, which provide downside protection and potential for additional fee income Incrementally higher coupon rates Diversification through exposure to borrowers that typically do not participate in the public debt markets The asset class has proven to be durable in a variety of market conditions and is best suited for investors that have strong legal and credit underwriting skill sets, along with long-standing market relationships. Private placement bonds Private placement bonds combine the duration of fixed-rate public corporate bonds with the legal protections and covenants that are contained in most bank loans. The bonds are unregistered debt securities that are sold to accredited investors via investment banks. Typical use of proceeds is similar to those of public bonds: refinancing debt, expansion, acquisitions, dividends, and stock buyback and recapitalization programs. Transactions range in size from less than $100 million to in excess of $1 billion. The total outstanding market for private placement bonds is approximately $500 billion. Annual issuance is typically $50 billion and an established secondary market trades approximately $3 billion to $5 billion per year. Maturities typically range from 5 years to 30 years, with flexible and longer tenors offered making it an attractive market for foreign and privately owned companies to issue term debt. Why issuers access the private market For decades, the U.S. private bond market has provided borrowers across the globe with consistent access to term funding. This was especially apparent during the global financial crisis when major debt capital markets became disrupted, yet the private placement market remained a viable place for companies to issue term debt. In the years following the financial crisis, the U.S. private placement market experienced increased cross-border issuance as a number of European banks curbed lending. Cross-border issuance typically ranges between percent of the overall market volume, with the creditor-friendly United Kingdom and Australian jurisdictions being the major source. Robert Diedrich, CFA Vice President and Lead Portfolio Manager, Insurance Advisory Annual private placement market volume (in billions of dollars) Source: Private Placement Monitor Percentage of issues rated NAIC 1 and NAIC 2, NAIC 1 30% 37% 36% 37% 34% NAIC 2 70% 63% 64% 63% 66% Source: Advantus and Private Placement Monitor. NAIC 3 issuance <1%. over

2 Issuers value the ability to have a diversified source of funding beyond bank loans or public bonds to meet a particular funding need. In other cases, the small size of an issue, appetite for non-standard maturities (e.g. 9 or 11 years), or the absence of a credit rating may rule out the public market. A company without a long credit history may also view the private market as a path to building a good reputation in preparation for an entry to the public bond market. In return for this access, they must issue wellcovenanted offerings to provide investors comfort regarding willingness of the issuer to maintain an investment grade rating profile. Some issuers prefer keeping financial and company information somewhat private this may be for trade purposes or to preserve confidentiality for family owned companies. Private bond issues do not require registration with the SEC or a rating from rating agencies. Although the company issuing a private bond must provide detailed information for underwriting, distribution is often limited to a select group of investors. Domestic vs. cross-border issuance 66% 57% 53% 54% 40% 34% 43% 47% 46% 60% Cross-border Domestic Source: Private Placement Monitor How private placement bonds compare Public corporate bonds Private placement bonds Bank loans Credit Quality Investment-grade Investment-grade Investment grade or high yield Security Unsecured Initially unsecured with limitation on priority debt Secured Covenants None/limited Typically parallel banks, may be less restrictive Comprehensive Prepayment Non-call or make whole provision Non-call or make whole provision Pre-payable at par Liquidity Registered Unregistered Unregistered Value for private placement investors In our experience, the private bond investor universe is comprised of approximately institutional firms. Investors consist largely of life insurance companies, in addition to asset managers and pension plans. Most of these firms have a lengthy private bond history, although new investors have recently shown increased interest. New investors to the private bond market often work in association with experienced private placement asset managers. In addition to higher yields, structural protection and diversification, investors value the opportunity for pre-purchase due diligence found in private bonds. Private bond holders can also build relationships with management at the time of the deal and maintain those relationships after purchase, which can be important if covenants come into play. Investors have the option to access the private bond market in one of two ways, either through direct origination with issuing companies, or by utilizing an agent to actively source and deliver new transactions. Issuers value the ability to have a diversified source of funding beyond bank loans or public bonds to meet a particular funding need.

3 Potential benefits provided by the agented market for both lenders and issuers: Avoid conflicts faced by direct originators acting as agent to both the issuing company and investor Reliable source of geographically diversified investment opportunities Better liquidity and fewer seller restrictions Ability to walk away from transactions without jeopardizing future deal flow Absence of volume-based incentives faced by originators Consistent source of capital, with term and structure flexibility Transparency in price discovery and more fluid market amendment negotiations Strengths and considerations for investors Private placements provide investors an opportunity to generate higher total returns versus holding a basket of similar rated public bonds. This is achieved by several factors: Structural protection. Covenant protections, a key differentiator between public and private bonds, provide downside protection to investors from financial and event risk. Covenants also ensure seniority in the capital structure, which, in the case of an event of default, typically result in higher recoveries for private placement investors. Covenants legally compel management to maintain key financial metrics. Examples include limits on leverage (i.e., debt/ebitda), restrictions on asset sales, and requirements to maintain minimum coverage ratios. Covenant violations can trigger default and/or compensation to bond holders through waiver or amendment fees, coupon bumps and prepayment premiums that can add basis points of additional fee income per year. Private placements exhibit lower credit migration risk as most companies that fall to below investment grade typically cannot comfortably comply with the covenants contained in most private placement bonds. Additional spread. Typically, private placements provide basis points of additional spread relative to public bonds. The incremental yield for private placements has traditionally compensated investors for the perceived lack of liquidity relative to public bonds. Diversification. A large number of private placement issuers do not issue debt in the public debt markets, thus providing investors additional portfolio diversification. Types of issuers accessing the U.S. private placement market range from utilities, industrials, infrastructure and project finance to professional sports leagues and stadiums/arenas. While the private placement secondary market is considerably smaller than the public secondary market, and the potential for resale can be limited for smaller transactions, liquidity is strong for performing, well-covenanted private bonds. This was evident during the global financial crisis, where some investors obtained liquidity by selling private placement bonds when they were unable to sell their public bonds. The incremental yield for private placements has traditionally compensated investors for the perceived lack of liquidity relative to public bonds. Financials 5% Consumer & Retail 5% Tech/Business Services 7% 2015 Issuance by sector Healthcare 3% Real Estate & Gaming 14% General Industrial 20% Sports, Media & Telecom 7% Source: Bank of America/Merrill Lynch 2015 Oil & Gas 2% Utility 20% Infrastructure 17%

4 Approximately 60 percent of transactions are not rated by a credit rating agency; therefore, investors in private placement bonds must have the capability to perform an independent assessment of credit risk. Additionally, private placement investors must also have the ability to underwrite covenant packages and legal jurisdictions. Demonstrating the advantages The following real life examples of common credit events highlight the strategic advantages of private placement covenants and the protection they provide. The value of covenants. An issuer with both public and private bonds outstanding experienced deterioration of credit fundamentals and a decline in profits following M&A activity. As a result, the public bonds fell to below investment grade and began trading well under par. However, the strong covenants of the private placement bonds provided protection to noteholders. Although they initially fell to below investment grade, the private placement notes were prepaid at Treasuries +50 basis points makewhole shortly after the triggering event. Ability to negotiate amendments. In another example, the cyclical downturn in energy markets tested the covenant levels of a private placement bond. Consequently, the Company requested amendments to the note allowing covenants for leverage and fixed-charge coverage to be temporarily loosened. The ability to negotiate directly with company management on behalf of private noteholders resulted in limits placed on capex and dividends. Noteholders received a coupon bump as well as an amendment fee, and obtained a partial prepayment at Treasuries +50 basis points makewhole. Expertise and experience count Private bonds demand extensive due diligence and this responsibility falls on the buyer. Investors must have considerable legal, credit and back office resources and expertise in order to effectively evaluate, negotiate, underwrite, price and monitor private bonds. Building those capabilities requires time and resources, which is why many investors form a relationship with an experienced firm that provides such expertise. Creating a strong private bond portfolio takes time. Investors must be selective and attentive once the investment is part of their portfolio. Proactive credit monitoring, ongoing review of covenant compliance, and periodic valuation analysis are necessary exercises in maintaining a healthy private portfolio. It takes an experienced hand to successfully tap the benefits of the private market. Investors can find that experience by working with an asset manager who has specific private placement underwriting and legal expertise, and solid private market relationships. Advantus Capital Management offers investors access to over 40 years of expertise, as well as our dedicated teams of experienced attorneys, private bond analysts and portfolio managers. Advantus Capital Management offers investors access to over 40 years of expertise, as well as our dedicated teams of experienced attorneys, private bond analysts and portfolio managers.

5 NAIC refers to the National Association of Insurance Commissioners and the ratings denote credit quality. NAIC 1 is assigned to obligations exhibiting the highest quality. Credit risk is at its lowest and the issuer s credit profile is stable. NAIC 2 is assigned to obligations of high quality. Credit risk is low but may increase in the intermediate future and the issuer s credit profile are reasonably stable. NAIC 3-6 are assigned to obligations considered below investment grade. Basis points refer to the percentage change in the value or rate of a financial instrument. One basis point is equal to 0.01% (1/100th of a percent). This information should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy. Investing involves many inherent risks, including the potential loss of the entire investment. The opinions expressed herein represent the current, good faith views of the author at the time of publication and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this article has been developed internally and/ or obtained from sources believed to be reliable; however, Advantus does not guarantee the accuracy, adequacy or completeness of such information. Predictions, opinions, and other information contained in this article are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and Advantus assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated. Advantus Capital Management is a subsidiary of Securian Financial Group. Approved For Use with the General Public Advantus Capital Management, Inc. All rights reserved. F DOFU