Senior Secured Loans An Alternative Way to Diversify an Income Strategy Alternative Thinking Series There is no shortage of uncertainty and risk facing today s investor. From high unemployment and depressed real estate prices to bailouts of European sovereigns and banks, investors are reminded daily of the fragile economic recovery and corresponding stock market volatility. Traditionally, investors flock to Treasurys during heightened periods of volatility as a means of capital preservation. But with Treasury yields currently at historical lows, an investor s flight to safety comes with the significant opportunity cost of lost income. Senior secured loans represent a $1.2 trillion asset class and can offer an investment opportunity for individuals who want an alternative way to diversify their income strategy. This is neither an offer to sell nor a solicitation of an offer to buy securities involving the assets described herein. An offering is made only by prospectus. This sales and advertising literature must be read in conjunction with the prospectus in order to fully understand all of the implications and risks of the offering of securities to which the prospectus relates. A copy of the prospectus must be made available to you in connection with any offering. No offering is made except by a prospectus filed with the Department of Law of the State of New York. Neither the SEC, the Attorney General of the State of New York nor any other state securities commission has approved or disapproved of these securities or determined if any related prospectus is truthful or complete. Any representation to the contrary is a criminal offense.
What Are Senior Secured Loans? Senior secured loans, also known as bank loans or leveraged loans, are a form of debt financing for private companies that are typically collateralized, or secured, by a company s cash flow and assets. Senior secured loans are used by companies to finance an expansion, fund an acquisition or for general operating purposes. Bank loans have been a staple of commercial banks for centuries and today are commonly used as a financing tool by private equity investors to finance acquisitions of companies. While senior secured loan borrowers are usually private companies, many have substantial scale and size; the average annual revenue of a large corporate senior secured loan issuer is over $1.5 billion. 1 Three features separate senior secured loans from other asset classes: floating interest rates, security and covenants. This paper will discuss each topic in detail as well as the diversification benefits of senior secured loans in an investor s portfolio. The paper concludes with a brief discussion of the opportunities available to individual investors seeking exposure to senior secured loans and criteria to consider when choosing an investment manager. Floating Rate Loans Not Your Typical Fixed Income Debt Instrument Senior secured loans and bonds are commonly grouped together in the broader category of fixed income investments. While true that both loans and bonds are debt instruments with a defined principal and maturity date, the two asset classes have several significant differences; one difference is how each performs in a changing interest rate environment. As compensation for lending a principal amount, loan and bond investors (lenders) are paid a negotiated interest rate (coupon), with the borrowed principal due at maturity. The interest rate a lender negotiates has two components. First, there is the credit spread, which takes into account the creditworthiness of the particular borrower and investment opportunity. The second component is often referred to as the base rate, and represents the general level of interest rates in the economy. In the case of senior secured loans, lenders are paid a credit spread over a short-term base rate, typically 3-month LIBOR (London Interbank Offered Rate). Short-term interest rates are commonly called floating interest rates because they reset or float on a regular basis. By paying investors a floating base rate, interest payments to senior secured lenders self-adjust to changes in market interest rates. Therefore, the economic value of a loan investment generally increases in a rising interest rate environment and falls in a declining rate environment as the income a lender receives rises or falls with the change in interest rates. Conversely, traditional bond securities pay lenders a fixed rate for the term of the investment. The coupon that bondholders receive never changes for the duration of their investment. If interest rates rise such that the rate on the bond is low relative to current market interest rates, the market price of the bond will change accordingly; bonds decrease in both relative economic value and actual market price as interest rates rise and they generally increase in value as interest rates fall. Three features separate senior secured loans from other asset classes: floating interest rates, security and covenants. 1 Improvement in the air, LoanStats (Jul. 2012), at 1, available at https://www.lcdcomps.com/lcd/download/6140/loanstats_0712_p1.pdf?rid=910&method=downloadresearchfile 2 Senior Secured Loans
Why is it important to hedge interest rate exposure with a floating rate investment? In the fourth quarter of 2010, the United States experienced a brief rising interest rate environment. The Federal Reserve announced Quantitative Easing 2, or QE2, in an attempt to stimulate the economy. In October 2010, prior to program launch, the 10-year Treasury yield was 2.38%; by mid-december, the 10-year Treasury yield had spiked to 3.52%, a 48% increase in approximately two months. The table below compares returns from the Credit Suisse Leveraged Loan Index (CSLLI), a commonly used index for senior secured loans, to other fixed income assets during this period. Figure 1 Q4 2010 Return (not annualized) Credit Suisse Leveraged Loan Index 3.30% Bank of America Merrill Lynch U.S. Corporate Bond Index -1.59% 5-Year Treasury Bond -2.66% 10-Year Treasury Bond -5.59% 30-Year Treasury Bond -9.85% Source: Bloomberg As can be seen from Figure 1, senior secured loans, with their floating rates, outperformed other fixed income securities during the rising rate environment of Q4 2010. Senior secured loans outperformed other fixed income securities during the rising rate environment of Q4 2010. In normal environments, the cost of hedging against the risks of rising interest rates is accepting potentially lower yields if interest rates were to fall. The current economic malaise has forced central banks worldwide to keep interest rates at historically low levels in an attempt to spur growth. With LIBOR trending well below its historical average and approaching 0% (see Figure 2), LIBOR-based investments can offer an interest rate hedge with minimal opportunity cost. While interest rates can go up or down, with current interest rates at historically low levels, the floating rate nature of senior secured loans is beneficial as it allows investors to participate in the upside of rising interest rates. Compared to fixed rate investments, floating rate senior secured loans have much less exposure to interest rate risk, which can help diversify an investor s portfolio. Figure 2 12% 10% 8% 6% 4% LIBOR 3-Month Interest Rates (1984 2012) (1984-2012) 4.5% Average 2% 0% 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Franklin Square Capital Partners 3
Seniority and Security The View from Above The second feature that distinguishes senior secured loans from other fixed income investments is their priority in repayment. Senior secured loans are senior because they usually comprise the most senior portion of a borrower s capital structure and are therefore the first to be repaid from a borrower s cash flows generally before bonds and equity. Loans are referred to as secured because they typically claim substantially all of a borrower s assets (such as inventory, property and equipment and real estate) as collateral. Being senior on the balance sheet and secured by collateral means that loans provide a more protected repayment stream to investors than investments that are unsecured or otherwise lower in the capital structure; senior secured loan credit losses have historically averaged less than half those of unsecured bonds. Priority of repayment translates into downside protection (see Figure 3). Senior secured loans historically trade at 66% of their stated par value in the event of default, with an ultimate recovery for lenders of 80%. This is the lowest loss given default of all corporate securities. Senior secured loan credit losses have historically averaged less than half those of unsecured bonds. Figure 3 100% Ultimate Recovery vs. Post-Default Trading Recovery 90% 80% 80% 70% 66% 64% 60% 50% 52% 49% 40% 30% 37% 29% 32% 20% 10% 0% Senior Secured Bank Loans Senior Secured Bonds Senior Unsecured Bonds Subordinated Bonds Ultimate Recovery Post-Default Trading Recovery Sources: Moody s Investors Service, S&P / LCD. (1) Ultimate recovery rate is calculated for the period 1987 2011. (2) Post-default trading recovery rate is calculated for the period 1982 2011. 4 Senior Secured Loans
Covenants Find Solutions Before Default Beyond seniority and security, there is a third feature of senior secured loans that separates it as an asset class from other fixed income investments. A loan credit agreement the legal document that binds borrower to lender, contains covenants that allow the lenders to take protective steps if a company s financial health begins to deteriorate. Covenants set boundaries for a borrower s financial conduct and minimum standards for the borrower s performance. If a borrower s financial condition shows signs of weakening, the credit agreement typically gives lenders an opportunity to seek remedies before default. While bond indentures also contain covenants, these covenants are usually less numerous, less stringent and less restrictive than those typically found in senior secured loan agreements. By having a seat at the table, loan investors are in a better position to discuss options with management and potentially negotiate a higher interest rate or other concessions in return for temporary relief. During 2012, covenant amendments led to a 1.13% increase in annual interest payments to loan investors. Figure 4 Quarterly Volume of Covenant-Relief Amendments (in (in $billions) of $) Fee Spread Increase 1Q09 $29.15 0.64% 2.47% 2Q09 51.79 0.55% 2.38% 3Q09 38.36 0.39% 2.90% 4Q09 20.26 0.42% 2.18% 1Q10 27.64 0.30% 1.48% 2Q10 18.99 0.19% 2.51% 3Q10 14.91 0.22% 1.60% 4Q10 7.92 0.26% 1.85% 1Q11 6.00 0.20% 2.29% 2Q11 18.17 0.29% 1.50% 3Q11 1.61 0.33% 1.83% 4Q11 4.51 0.21% 1.63% 1Q12 10.15 0.47% 1.44% 2Q12 5.18 0.26% 2.00% 3Q12 8.49 0.27% 1.00% 4Q12 19.19 0.23% 0.79% Sources: S&P Capital IQ, Leveraged Commentary & Data Covenants in loan agreements can be both financial and operational. Standard documentation typically includes minimum credit ratios, such as cash flow to interest, and may include restrictions in changes to management. Companies may seek relief for a variety of reasons ranging from weak financial performance to special transactions, such as acquisitions or a large capital investment. The return benefits to a lender from a covenant amendment are substantial. In 2012, companies with $43 billion in loans outstanding requested some form of a covenant amendment, paying lenders on average 0.30% of the principal loan outstanding at the time of the request and an additional 1.13% in interest on an annual basis (see Figure 4). Covenants are structured to give lenders protection and compensation in the event their initial investment criteria have changed. Franklin Square Capital Partners 5
Security and Floating Rates Create Stability and Diversification Loan returns have been mostly stable, positive and consistent for the past 20 years (see Figure 5). Through 2012, the Credit Suisse Leveraged Loan Index had a 3-year annualized total return of 7.0%, 5-year annualized total return of 4.8% and a 10-year annualized return of 5.5%. From 1992 to the present, the CSLLI experienced a negative annual return only in 2008 during the worldwide credit crisis. Falling almost 29%, secondary loan prices plummeted as shockwaves caused by the Lehman Brothers bankruptcy reverberated through financial markets. During this time, many believe prices for loans did not reflect their fundamental value but rather the cost of liquidity as most loans continued to make scheduled interest payments. Importantly, the loan market s recovery was more notable than its fall the CSLLI s return in 2009 was an impressive 44.5%. Figure 5 50% 40% 30% 20% Annual Loan Returns Loan returns have been mostly stable, positive and consistent for the past 20 years. 10% 0% -10% 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012-20% -30% Credit Suisse Leveraged Loan Index Annual Return One factor that contributed to the loan market s remarkable 2009 recovery and its history of positive returns is a credit concept known as the pull to par. When loans trade in the secondary market, the trading price generally reflects numerous variables from current market sentiment to relative value distinctions. Though prices can often fluctuate, loans are typically pulled to their principal value, or par, as they near maturity. Loans trading at a price discount therefore create an inherent opportunity as the very nature of the investment is to trend to 100% of its par value. The financial crisis of 2008 created such an opportunity as the weighted average loan price in the CSLLI fell from 94.4% of par at year-end 2007 to 62.3% of par at year-end 2008. When market conditions improved, loan prices trended back to par the weighted average loan price in the same index was 94.1% of par by yearend 2010, over 50% higher than only two years before. In addition to providing stability, senior secured loans exhibit low correlation to other asset classes and can be used to lower the risk of a portfolio without sacrificing return. Correlation is the statistical measure of the degree to which the movements of two variables are related. Correlation is measured on a scale of -1 to +1. Investments with a positive correlation tend to change in value at the same time in the same direction; investments with a negative correlation tend to move in opposite directions. As seen in Figure 6, senior secured loans as measured by the CSLLI are not well correlated to more traditional asset classes, such as 10-year U.S. Treasurys, investment-grade bonds, REITs, commodities and public equities. Senior secured loans can reduce a portfolio s overall risk as they tend to perform independently of traditional assets, which can be extremely important when stocks and bonds suffer declines in value. 6 Senior Secured Loans
Figure 6 Correlations of Senior Secured Loans vs. More Traditional Asset Classes Senior secured loans exhibit low correlation to other asset classes and can be used to lower the risk of a portfolio without sacrificing return. -1-0.75-0.5-0.25 0 0.25 0.5 0.75 1 Investment Opportunities for Individual Investors From its beginnings as a relationship-driven business between commercial banks and private borrowers, the loan market has always been an institutional market available to institutional investors. As the need for capital preservation and yield drives more individual investors to the asset class, new investment vehicles have been designed to meet the increased demand. Loan mutual funds, loan exchange traded funds (ETFs) and business development companies (BDCs) are the three most common vehicles available for individuals to invest in senior secured loans. Each of these fund structures offers different risks, fees, strategies and investment time horizons. Investors should speak to a financial advisor to understand the risks and consider their goals before investing. Summary REITs Stocks Commodities Treasurys Bonds Source: Bloomberg; Standard & Poor s LDC. National Association of Real Estate Investment Trusts (0.496) S&P 500 Total Return Index (0.417) Dow Jones AIG Commodity Total Return Index (0.349) Merrill Lynch Investment Grade Corporates (0.313) 10-Year Treasurys (-0.322) Data includes the period from 1992 2011. Senior secured loans represent one option for investors seeking to diversify their income streams while maintaining a focus on capital preservation. Notable attributes of senior secured loans include the following: Floating rates can offer a hedge against rising interest rates and inflation; Security and seniority in the capital structure provide solid recovery rates in the event of default; Covenants in a loan credit agreement can provide investors with the opportunity to restructure a loan rather than waiting for a payment default, potentially improving recoveries and economic terms; and Low correlation to traditional asset classes can stabilize a portfolio s returns during periods of heightened volatility in the public bond and equity markets. Historically available only to institutional investors, the benefits of senior secured loans should continue to find a broader audience as investment opportunities for individual investors expand. Keep in mind that all investments involve some degree of risk. Investments in senior secured loans are subject to significant risks, including the possibility of default and loss of principal. There can be no guarantee that any investment strategy will be successful. For instance, the collateral securing senior secured loans over time may decrease in value, lose its entire value or fluctuate based on the performance of the portfolio company, which may lead to a loss in principal. An offering is made only by the applicable prospectus, which can be obtained through a financial advisor and should be read carefully by an investor before investing. Investors are advised to consider the investment objectives, risks, charges and expenses carefully before investing. Franklin Square Capital Partners 7
Risk Factors An investment in the shares of a fund that invests in senior secured loans (a Fund ) may involve a high degree of risk and may be considered speculative. The following are some of the risks an investment in the shares of a Fund may involve; however, investors should carefully consider all of the information found in the section of the prospectus of the applicable Fund entitled Risk Factors before deciding to invest. Because there may not be a public trading market for the shares of a Fund and the Fund may not be obligated to effectuate a liquidity event by a specified date, it is unlikely that investors will be able to sell their shares. While a Fund may conduct quarterly tender offers for its shares, in many cases, only a limited number of shares may be eligible for repurchase, and a Fund may have the ability to suspend or terminate its share repurchase program at any time. Investors may not receive distributions, or a Fund s distributions may not grow over time. A Fund may pay distributions from offering proceeds, borrowings or the sale of assets, and each Fund may not establish limits on the amount of funds that such Fund may use from net offering proceeds or borrowings to make distributions. A Fund s distribution proceeds may exceed its net investment income. Therefore, portions of the distributions that a Fund makes may represent a return of capital to investors for tax purposes. These Funds may have an investment strategy focused primarily on privately held companies. An investment strategy focused primarily on privately held companies presents certain challenges, including the lack of available information about these companies. These Funds may invest in small and middle market companies. Investing in small and middle market companies involves a number of significant risks, any one of which could have a material adverse effect on a Fund s operating results. A lack of liquidity in certain of a Fund s investments may adversely affect its business. These Funds are often subject to financial market risks, including changes in interest rates, which may have a substantial negative impact on a Fund s investments. These Funds may borrow funds to make investments, which increases the volatility of the Fund s investments and may increase the risks of investing in the Fund s shares. These Funds may have limited operating histories and therefore may be subject to the business risks and uncertainties associated with any new business. 2929 Arch Street, Suite 675 Philadelphia, PA 19104 215-495-1150 www.franklinsquare.com Franklin Square Capital Partners is not affiliated with Franklin Resources/Franklin Templeton Investments or the Franklin Funds. This is neither an offer to sell nor a solicitation of an offer to buy the securities of FSEP or FSIC II. The offering of these securities is made only by a prospectus. The information presented herein is provided for informational use only and should not be considered investment advice. The views expressed above are subject to change at any time based on market or other conditions, and Franklin Square disclaims any responsibility to update such views. These views should not be relied on as investment advice, and because investment decisions for a Franklin Square Fund are based on numerous factors, may not be relied on as an indication of the investment intent of any Franklin Square Fund. Neither Franklin Square, its Funds nor their respective affiliates can be held responsible for any direct or incidental loss incurred as a result of any investor s reliance on the opinions expressed herein. Investors should consult their tax or financial advisor for additional information concerning their specific situation. 2013 Franklin Square Capital Partners WP-FSCP-INV1 5/10/2013