2018_12_10 — “A Case for Strong (Covenant Heavy) Credit”

December 10, 2018

A Case for Strong (Covenant Heavy) Credit

Interest rates are wavering: The U.S. economy is in a long cycle (some would say late cycle) recovery since 2009. Overall, stocks, bonds, and real estate have performed well over the last nine years even though 2018 has been rough for most asset classes except cash equivalents and secured debt. Although there has been for the past two years a general belief that we are finally in a long awaited rising rate inflationary environment, the steadfastness of that rate rise is questionable as A) The U.S. yield curve flattens, B) Inflation continues to remain low in a global economy awash in supply, and C) Gross domestic production (GDP) growth decelerates.

Move up the capital structure: In this scenario, risk averse investors might look towards well underwritten covenant heavy and secured debt for income and total return. In a mildly declining, flat, or mildly rising rate environment, such debt should maintain a healthy spread above Treasuries and face little risk from interest rate movements because of, 1) The spread built into the loans, 2) The usual short time frame of the term loans (often under three years), and 3) The ability of the covenants to protect principal and interest in an adverse scenario. Such loans would not be a cash substitute, but could replace some fixed income and equity exposure by moving up the capital structure.

Some middle market credit fund firms focus on:

I. $1MM to $30MM transactions on mission critical equipment finance, corporate credit, or loans — in stable but out of favor industries (trucking, rail, shipping, construction, energy, mining, agriculture) where there are few sources of capital available.

II. Senior secured direct loans of $5MM to $25MM to lower middle market specialty finance companies often structured with floating rate coupons of LIBOR +10% to +14%, providing an inflation hedge in a rising rate environment. These specialty finance companies lend mostly to consumers and small businesses in the U.S. Senior secured loans with asset protection and regular cash flow help provide downside protection and recovery in case of default.

A finance company lending to another finance company is often called “rediscount lending” or “rediscounting”. It provides a double-layer of first loss protection as the borrower puts up subordinated equity capital to the loan, and its borrowers provide subordinated capital to its loan. For example, if the lender advances 75% against an 80% advancement of the borrower, the lender’s effective advance is approximately 60%.

Consumer Assets  Credit card receivables  Installment loans  Auto loans  Niche medical receivables  Small ticket consumer leasing Commercial Assets  Accounts receivable  Purchase orders  Merchant cash advances  Small business loans  Rediscount facilities  Trade finance Niche Financial Assets  Bankruptcy receivables  Equipment leasing  Tax liens  Litigation receivables Opportunistic Assets  Aircraft parts & equipment  Shipping assets  Transportation leasing  Select energy assets

Loans can have underlying asset profiles that provide ongoing cash flow/amortization throughout life of the loan which reduces reliance on an outside event to repay debt, thus reducing exit risk.

Many other examples such as business development companies (BDCs), large covenant heavy private lenders in the +$100MM arena, mezzanine lenders, and other specialty finance firms also exist, and can be reviewed at a later time.

Michael Ashley Schulman, CFA

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Disclosure: The views and opinions expressed are those of Michael Ashley Schulman, CFA and are subject to change without notice. The views and opinions referenced are as of the date of initial publication, may be modified due to changes in the market or economic conditions, and may not necessarily come to pass. Forward-looking statements cannot be guaranteed; neither can backward-looking nor current-looking statements. This material is provided for informational purposes only and does not constitute an offer or solicitation to purchase or sell any security or commodity or invest in any specific strategy. It is not intended as investment advice and does not take into account each person’s or investor’s unique circumstances. Information has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed. Past performance is no guarantee of future results.

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Michael Ashley Schulman

Avid traveler and art fan, also Partner & Chief Investment Officer @Running Point Capital, a multifamily office and ultra high-net-worth money-management firm