With the large universe of investment opportunities

Investing The Opportunity in Middle-Market Direct Lending Thomas Martin Assistant Vice President Investment Strategy Analyst With the large universe of investment opportunities available in public fixed income markets, putting money to work in a middle-market direct lending (MMDL) strategy might seem unnecessary in most market environments. The asset class is an unfamiliar one for investors because, even though business loans were one of the world s first financial products, the activity of lending to private companies has typically been dominated by banks. Yet despite this history, there is a dearth of bank capital currently being allocated to making loans, which has opened up opportunities for private investors to fill this funding gap on attractive terms. While investors can typically receive liquidity, price stability and attractive yields by simply owning investment grade bonds, the current market environment requires investors to look harder for opportunities in fixed income. Most notably, other investors have shown a willingness to reach for yield by extending the duration of their portfolios, something BBH has purposefully rejected. Recognizing these challenges, BBH feels that an investment in directly-originated middle-market loans currently offers attractive risk-adjusted returns for our clients, while providing an added benefit for clients with a need for current income. Market Environment The middle market can be broadly defined as companies that generate $50-500 million in revenue or $5-75 million in EBITDA 1. Above these levels, a larger firm would typically address its funding needs through either the broadly-syndicated loan (BSL) market or the high-yield bond market. Below these levels, companies that produce under $10 million in EBITDA would obtain debt financing through Small Business Administration loan programs or from local banks. According to the National Center for the Middle Market, which uses a broader definition of the middle market that includes firms with revenues of $10 million - $1 billion, there are roughly 200,000 middle-market businesses in the U.S., which employ 34% of the country s workforce and contribute 33% of our private sector GDP 2. Prior to the 2008 credit crisis, the primary providers of capital to the middle market were: (1) national and regional banks, (2) specialty finance companies (such as GE Capital and CIT Group), (3) collateralized loan obligations (CLOs) and (4) to a lesser extent, hedge funds and private equity funds. Currently, outstanding commercial and industrial loans made by U.S. commercial banks are below their peak level reached before the credit crisis (see following chart). In contrast, economic output in the U.S regained its prior peak in 2010 and currently stands 12% above its September 2008 level, suggesting that there is an incremental demand for loans. In addition, GE Capital and CIT Group, two public companies long known for making middle-market loans, have sharply contracted their lending activity. GE Capital has decreased the portion of its balance sheet devoted to middle-market lending in the U.S. from $105 billion in 2008 to $73 billion at the end of 2012, and CIT Group had commercial loans outstanding of $22 billion in 2008 versus $8 billion in 2012 3. Instead of allocating internal funds to making loans, most bank profits have been used to rebuild capital ratios, which took a hit in the credit crisis. And while CLO activity has rebounded, it, too, remains well below its pre-crisis peak. Hedge funds are active in the space but play a smaller role. Partially offsetting these trends is 1

BBH InvestorView While investors can typically receive liquidity, price stability and attractive yields by simply owning investment grade bonds, the current market environment requires investors to look harder for opportunities in fixed income. 2 the rise of Business Development Companies (BDCs). BDCs are publicly-traded entities that provide permanent capital for their parent companies to make middle-market loans, and capital has been flowing to this space via new equity offerings. 1,800 1,600 1,400 1,200 1,000 Amount (in billions) 800 U.S. Commercial Banks Commercial & Industrial Loans ($ Billions) 1,602 Source: Federal Reserve H.8 Report 600 2000 2002 2004 2006 2008 2010 2012 $120 $100 $80 $60 $40 $20 $0 Change in Commerical Lending Base for GE and CIT $105 GE $73 Sources: CIT, GE Company Reports. $22 CIT $8 1,571 2008 2012 Another worthwhile distinction to make is one between the upper and lower middle market, which have distinct supply and demand characteristics. Roughly speaking, the lower middle market comprises companies with $10-30 million of EBITDA, and the upper middle market is made up of companies with $30-50 million and up of EBITDA. Our analysis of the market environment suggests that there is more capital taking advantage of the upper middle-market opportunity set, and as a result lending terms have come under pressure. The dynamic in the upper middle market is similar to that in BSLs, in which inflows have made that space a borrower-friendly environment. As a result, we believe that it is possible to identify managers who are focused on the lower middle-market opportunity set, provided that they employ a rigorous credit underwriting process that protects investor capital. MMDL vs. BSL Fundamentals Before allocating capital to a relatively illiquid MMDL strategy, investors must also consider the alternative of investing in a BSL mutual fund, which represents the most direct comparison to MMDL and offers daily liquidity. Both types of loans are senior, secured obligations, which have a first claim on the assets of a company in the event of a bankruptcy, and both carry floating interest rates, meaning they are susceptible to minimal interest rate risk. Besides differences in liquidity, another key distinction between these markets is the strength of lending terms and credit protections. Due to the perceived riskiness of middle-market loans (almost all of which do not carry credit ratings) and the difficulty investors have accessing the asset class (private funds are available only to accredited and qualified clients), at the margin, the supply-demand balance in the middle market is more favorable to investors and affords them many additional protections. The following sections compare the fundamentals of MMDL with the more familiar BSL market. Leverage Levels Middle-market lenders typically lend at lower leverage levels (measured by debt/ebitda ratios) than in the BSL market. Based on a survey of lenders BBH has spoken to in the lower middle market, on average there is close to a full turn of leverage (i.e. 1.0x EBITDA) difference between the two markets, which prevents potentially higher variability in middle-market companies operating results from translating into substantially higher frequencies of default. Spreads Because middle-market loans are floating-rate instruments, interest payments are determined based on a spread above LIBOR 4, and these spreads are higher in the middle market to compensate for what is perceived to be the higher levels of credit

How Companies Obtain Long-Term Debt Financing Typical Lenders Collateral Coupon Type Credit Ratings 5 Liquidity/ Tradability Accessibility for Individual Investors Investment Grade Bonds Markets Unsecured Fixed-rate AAA-BBB Liquid, High-Yield Bonds Markets Unsecured Fixed-rate BB and below Liquid, Broadly-syndicated Loans (BSLs) Markets, CLOs (see definitions below) Secured Floating-rate BB and below Semi-liquid, Middle-Market Loans/ Commercial Loans National and Regional Banks, Specialty Finance Companies, Private Lending Funds, CLOs, BDCs (see definitions below) Secured Floating-rate Unrated Illiquid, Not Private funds for Accredited/Qualified Investors, BDCs Small Business Loans/ Commercial Loans Local Banks, SBA Programs Secured Both Unrated Illiquid, Not SBICs (see definitions below) Definitions Syndicated: Refers to the fact that oftentimes multiple banks arrange (syndicate) the financing (source lenders/ investors). Collateralized Loan Obligations (CLOs): A structured security created in which the underling collateral and cash flow is provided by leveraged loans. The product is then segmented into various tranches offering different levels of credit risk and interest payments. Business Development Companies (BDCs): A form of corporate organization in which private equity style funds that invest in small businesses trade on public markets. Created in 1980 amendments to the Investment Company Act of 1940. Small Business Investment Companies (SBICs): A public-private partnership program run through the Small Business Administration (SBA), allowing approved private funds to make government subsidized loans to small businesses. risk present in smaller companies. According to data from T. Rowe Price, current BSL and middle-market spreads are wide by historical standards, and across a portfolio of loans, this provides a margin of safety, should defaults in the middle market turn out to be higher than those in BSLs. This spread is currently 1.8% whereas for most of the 2005-2009 period, there was no discernible difference between middle-market and BSL spreads. LIBOR Floors With LIBOR at historically low rates (25 basis points (bps) as of September 25th 6 ), lenders have negotiated LIBOR floors into deals that specify a minimum level for this reference rate used in coupon calculations. While greater than 90% of BSLs are issued with a LIBOR floor, the level of that floor has also decreased over the past year from 125 bps to 100 bps 7, whereas lower middle-market lenders have been able to keep LIBOR floor levels closer to 125 bps. This does mean that middle-market loans will not benefit from the first 100 bps increase in short-term rates, but BBH is not as concerned about short-term rates rising as we are long-term rates. Upfront Fees Another negotiating point for loans is the upfront fees lenders receive for making a loan. As of September, BSL lenders have received an average of 60-100 bps in upfront fees for new issues over the past four months. In the lower middle market, lenders can typically get 200 plus bps in upfront fees. Amortized over an assumed three year life, lower middle-market loans generate 40-50 bps in incremental annual yield because of these fees. Call Protection BSL loans typically come with what is known as soft call protection, which means that the penalty to issuers for pre-paying their loan before maturity is not particularly burdensome. A common arrangement in the BSL market is a call price of 101 (meaning a 1% penalty) the first year and, possibly, 100.5 (a 0.5% penalty) in the second year. Currently those terms are getting pushed towards six months of call protection. This is a big deal to loan investors, because call protection compensates lenders if a borrower wants to prepay their loan to take advantage of lower interest rates. In the lower middle market, call protection terms still fluctuate but are relatively more stable through a range of credit environments. Based on BBH s research, lower 3

BBH InvestorView While we fully expect that capital will continue to flow to the middle market, we also believe that terms will prove to be more resilient as banks remain capital constrained, CLOs are subjected to tighter risk constraints and private capital only gradually takes advantage of this opportunity. middle-market lenders can often receive call protection premiums of 3% in year 1, 2% in year 2, and 1% in year 3. Covenants A highly desirable feature of loans is that credit agreements typically contain maintenance covenants, which provide ongoing hurdles for the borrower s financial performance, such as maximum debt/ebitda leverage levels or minimum EBITDA/interest expense ratios. A violation of these covenants may accelerate the repayment of the debt, require an additional infusion of equity by a private equity sponsor or allow the lender to reprice their loan by demanding a higher interest rate. In 2013, over 50% of the loans in the BSL markets have been so-called covenant-lite, meaning that they do not contain maintenance covenants but only bond-like incurrence covenants, which prevent borrowers from taking specific actions like issuing more debt 8. In the lower middle market, it is possible to find lenders who are able to demand (and receive) maintenance covenants in almost all market environments. In addition, these covenants are purposely set with less headroom than in the BSL market, meaning that a limited deterioration in financial performance (sometimes only a 10-15% decline in EBITDA) will force a borrower back to the negotiating table with their lender. Covenants provide critical protection for creditors in the event of deterioration in a borrower s financial health, and BBH views strong covenant protections as essential. Conclusion No investment comes without risks, and lending to small companies is no exception. The primary risk in any credit strategy is borrower default that leads to a loss of principal. When comparing BSL and MMDL, it is thus important to compare loan loss histories to understand the relative credit risk. Our research suggests that, in large part due to the more creditor-friendly terms in the middle market, historical average credit losses (defaults net of recoveries) are similar, though there is substantial variation among lenders, underscoring the importance of choosing a good manager. In addition, there are many other important facets of the MMDL opportunity set beyond the scope of this article, and interested clients should reach out to their relationship manager to discuss this asset class in more detail. While we fully expect that capital will continue to flow to the middle market, we also believe that terms will prove to be more resilient as banks remain capital constrained, CLOs are subjected to tighter risk constraints and private capital only gradually takes advantage of this opportunity. In today s challenged fixed income environment, adding MMDL as part of a larger fixed income strategy can provide investors with attractive absolute levels of return and current income, which adequately compensates them for the credit and illiquidity risks inherent in the asset class.f 1 Earnings before interest, taxes, depreciation and amortization. 2 The Market that Moves America: Insights, Perspectives, and Opportunities from Middle Market Companies. National Center for the Middle Market. October 2011. 3 GE and CIT company reports. 4 London Interbank Offered Rate a measure of the cost of short-term, unsecured funding that high-quality banks provide to each other. 5 S&P Credit Ratings. 6 Source: Bloomberg. 7 S&P Capital IQ LCD Weekly Wrap September 5, 2013. 8 S&P Capital IQ LCD Weekly Wrap September 5, 2013. 4

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