As Q4 earnings season winds down, it is interesting to see the impact of the oil crash and the general race to zero on the results for large, publicly traded debt investors.  Most will likely try to blame poor results on energy investment write downs, though it is likely there is a deeper, longer term problem.  Clearly, one quarter doesn't tell the whole story.  Still, we do think it will be increasingly difficult for large pools of capital to find yields that meet their return bogeys.  This will result in either greater risk taking OR more leverage, both of which generally lead to bad outcomes in the not-too-distant future.  Caveat emptor!

The same but different

Earnings season is in full swing and not just the trade press have been full of debate about which PE firms were hardest hit by the sharp plunge in oil prices in the last quarter of 2014; Carlyle, Apollo and KKR – some of the biggest names all reported sizeable write-downs.

But these are, in the main, paper losses. If or, quite likely when, oil prices recover, many of those investments will similarly benefit. It was the performance of credit that PDI kept a sharp eye on, and the message from David Golub, of Golub Capital, was an interesting one.

“We’re finding middle-market junior debt to be downright unattractive right now. Attachment points are too high, pricing is too low and structural protections, including covenants, are weak. This is an area where we have not seen a meaningful degree of widening—spread widening or structure improvement—since September. We think this is a situation where there are too many players chasing too few middle market junior debt deals and consequently we’re sticking with our strategy of de-emphasizing junior debt at this time,” Golub said.

This was a salutary reminder that segments of the credit market are getting congested as firms look to redirect and refocus their strategies.

Notable too was Apollo Global Management’s results, which failed to meet analysts’ estimates. The firm’s actual economic net income (ENI) per share of 23 cents, missed the consensus estimate of 38 cents and recorded a whopping 80 percent drop from 2013’s figure of $1.12 per share.

Much of Apollo’s poor performance can be laid at the door of the energy sector. It has a 40 percent stake in EP Energy, which has taken a massive hit in terms of stock price.

But it is the roughly $67 million year-on-year fall in ENI from the firm’s credit business that should sound a warning to debt investors. The firm’s official earning statement clarified the reasons for the fall a little: "The year-over-year decrease in ENI of $66.8 million was primarily driven by a net reversal of carried interest income of $33.5 million during the fourth quarter ended December 31, 2014, compared to carried interest income of $74.2 million for the same period in 2013.”

So as credit returns slowed, the firm failed to reach the target at which carried interest kicked in across a large portion of its credit business. A portion of that, again, can be attributed to the volatility in the energy sector – before private funds can make money from the dislocation in energy markets, they must take the hits - and Apollo blamed energy for much of its credit pain. Yet without a full breakdown it’s hard to quantify the exact toll, but it seems unlikely it can be entirely blamed on slumping oil prices.

Private Debt Investor does not believe that medium- to long-term investment decisions should be based on a single bad quarter of course. In fact, reporting requirements sometimes seem geared solely towards the more volatile equity markets. Private debt investing is different to that.

Yet this earnings season should not be wholly discounted, as it evidences that credit targets in some areas are proving much harder to meet. The market should take note and remember that flexibility is key to sustaining success. Just be careful you and 100 of your competitors aren't trying to do the same thing.

Private credit markets offer investors double-digit returns

One direct lending fund returned 12.7% last year; seen as alternative to measly returns on bonds

Aug 15, 2014 @ 1:47 pm

By Jeff Benjamin of Investment News

As traditional bond funds scramble to navigate around the threat of rising interest rates, a growing number of investors and financial advisers are tapping into private credit markets, thanks to an expanding network of entry points.

“It's a great concept, but it's definitely a matter doing enough due diligence to make sure you like the company you're doing business with,” said David Reyes, founder of Financial Architecture, a financial advisory firm that has been allocating client assets to the private credit markets for nearly a year.

When stacked against traditional bond funds that carry both inflation and interest rate risks, Mr. Reyes described the private credit markets as a “no-brainer, because it's a natural to take money out of bond funds and replace that allocation with this kind of investment.”

What investors and advisers like Mr. Reyes are tapping into is a growing niche of the so-called peer-to-peer lending market, which is expanding by filling gaps ignored by traditional banking systems.

“We are targeting a market that was underserved by banks and was being overcharged by other alternative lending options,” said Ethan Senturia, chief executive of Dealstruck Inc., one of the growing list of no-balance-sheet lending companies that rely on outside investors to capitalize and hold the loan portfolios.

That's where the investment opportunity comes in.

Companies like Dealstruck are handling the upfront and operational lending issues for loans of between $50,000 and $250,000 — taken mostly by small businesses — which are capitalized by outside investors for minimums starting at $5,000.

Even though the minimums are sometimes low, this is still considered a private investment arena, and investors must meet the same net-worth standards required of hedge fund investors.

Mr. Senturia, whose firm recently made its 100th loan after less than a year of actively lending, said firms like his are taking market share from the $10 billion cash advance industry, and from the $125 billion factoring market, in which companies finance the sale of their own products.

The loans, which typically have durations of less than two years, come with interest rates of between 15% and 36%.

“Our rates are higher than those charged by banks, but they are much, much lower than the alternatives, which can sometimes mean rates in the triple digits,” Mr. Senturia said.

Brendan Ross launched a hedge fund in November 2012 for the specific purpose of investing in this category of small private loans.

The Fund generated a 12.7% return after fees and expenses last year. And the fund is currently up 6.7% through July.

That compares to a 2% decline by the Barclays U.S. Aggregate Bond Index last year, and a 3.7% gain this year through July.

“All I do is buy and hold loans of between six and 18 months in duration that are amortizing daily,” Mr. Ross said. “The whole idea is to focus on the part of the credit market where borrowers are paying the most interest.”

While the loan rates, which represent income to investors, sound high, the reality is less sensational because the loans are often paid off early, and they are structured like a home mortgage where the interest is constantly being applied to a shrinking principal.

For example, a $100,000 one-year loan at a 20% interest rate will cost the borrower $10,000, or 10%, if all payments are made on schedule.

Eric Thurber, one of the founders of Three Bridge Wealth Advisors, uses Mr. Ross' hedge fund for his clientele, which is made up of wealthy families.

“It's a relatively new investment for us,” he said. “But we are allocating to less traditional fixed income than we have in the past, and about half of our client portfolios are allocated to alternative and illiquid investments.”

While liquidity is usually an issue with private investments, the short duration of the loans and the fact the portfolio is turning over at a 20% monthly rate makes liquidity less of an issue, according to Mr. Ross, who provides his 85 investors with liquidity on 35 days' notice.

The default risks are similar to those faced by any lending institution. But because the loans are set to fixed rates and are held to maturity, the portfolio is uniquely shielded from interest rate and inflation-related risks.

Mr. Ross said the category has a 7% annualized default rate, and that his portfolio's break-even point would kick in if the default rate got above 22%.

“Our average borrower has been in business for 12 years, at an average age of 51, and has an average credit score of 680, with business revenues of between half a million and $55 million,” he said. “That's the sweet spot we're dealing with — the same group of businesses that was once being served by community banks.”

DebtX CMBS Loan Prices Increase Modestly in May

Boston, MA , July 01, 2014

DebtX, the largest marketplace for loans, said that prices of Commercial Real Estate loans underlying the CMBS universe were up modestly in May 2014 compared to April 2014.

“CMBS prices rose due to improving debt service coverage, as well as a small shift in the yield curve,” said DebtX Managing Director Will Mercer. “Prices in the secondary loan market also gained during May. Demand for all types of product continued to be as strong as we have ever seen.”

DebtX reported the following for May 2014:

• CMBS loan prices. DebtX priced $843 billion in CRE loans that collateralized US CMBS trusts at the end of May. The estimated price of whole loans securing this US CMBS universe increased to 95.6% at the end of May from 95.2% at the end of April. Prices were 91.4% in May 2013. From last month, median adjusted LTV's have remained at 60%, while median debt service coverage ratios have increased to 1.41%. Median estimated loan yields have decreased to 4.4%.

• Impaired performing loan prices. The weighted average price for impaired performing loans traded at DebtX’s marketplace in May 2014 was 79.6%.
• Non-performing loan prices. The weighted average price of non-performing CRE loans traded at DebtX’s marketplace in May 2014 was 47.5%.

Your loss, our gain

By: Evelyn Lee at Private Debt Investor

PUBLISHED: 02 June 2014

A wave of distressed US property loans could be hitting the market once again, which could present a new investment opportunity for private equity real estate firms, writes Evelyn Lee.

In the wake of the global financial crisis, some of the most high-profile and hotly-pursued real estate investment opportunities in the US came from the Federal Deposit Insurance Corporation (FDIC), which began selling off large numbers of nonperforming property loans from recently failed banks in early 2008.

Although the volume of structured transactions – as these partnerships between the FDIC and the private sector are known – has tapered off in the past couple of years, change could be in the air as private equity real estate firms prepare for what is expected to be a new batch of failed US bank assets. This time, however, the sellers would be banks that bought troubled mortgages from the FDIC beginning in 2008, with the assets covered under so-called loss-share agreements, whereby the federal agency reimburses 80 percent of losses that the bank incurs on the bad loans, up to a certain threshold.

With the coverage period for commercial assets typically lasting five years and 10 years for residential loans, some of the shared-loss agreements now are reaching expiration. According to one general partner that is planning to invest in loss-share assets, approximately $35 billion of assets currently covered under the agreements consequently are expected to hit the market over the next 12 months. Such assets, commonly referred to as covered assets or loans, currently total $78.2 billion, according to FDIC.

BankUnited has already sold off some of its covered assets in a portfolio sale earlier this year. In 2009, the Florida-based bank signed two loss-sharing agreements with the FDIC, covering about $11.7 billion worth of commercial loan assets, single-family loans, other real estate-owned assets and securities that previously were held by the defunct BankUnited FSB.

In an April earnings call, Rajinder Singh, BankUnited’s chief operating officer, revealed that the bank had ended its commercial loss-share agreement with the FDIC by agreeing to sell half of its unresolved covered commercial loans in late March, with the intention of retaining the better-performing half of its covered commercial loan portfolio. While Singh did not reveal the identity of the buyer, bidders on the deal were believed to include Colony and Oaktree, according to sources familiar with the transaction.

“We got very good pricing for that portfolio,” said Singh during the call. “The numbers generated about $11 million [to the] bottom line on a pre-tax basis.” Meanwhile, BankUnited’s residential loss-share agreement, which accounts for the majority of the bank’s covered loans, will remain in effect for another five years.

BankUnited, whose commercial loss-share agreement was set to expire on May 21, is said to be the first portfolio sale of covered assets to have been approved by the FDIC. However, future portfolio sales of such assets may be limited.

“We expect bulk sales will be the exception and only will be approved after other resolution strategies have been fully considered,” an FDIC spokesman said. In a 2012 letter to banks with shared-loss agreements, Pamela Farwig, deputy director in the agency’s division of receiverships and resolutions, stated that the FDIC will consent to a portfolio sale only if the bank has demonstrated that such a transaction would be the least costly resolution as compared to alternative strategies, among other requirements.

Instead, bulk sales are expected to pick up once the assets are no longer under the FDIC’s purview. “My sense is we’re going to see more product after these loss-share agreements expire and the provision against bulk sales go away, then banks can do what they want with them,” said one GP. He anticipated that window of opportunity for these portfolio sales will span the next two years in tandem with the expiration of the five-year shared-loss agreements, the bulk of which were drafted in 2009 and 2010.

Lawrence Kaplan, an attorney in the corporate practice of law firm Paul Hastings, noted that, in addition to the looming expiration of the agreements, banks now are in a better position to sell the loss-share assets because of improved real estate fundamentals. “If the market was going down, there would be no incentive to sell because the FDIC would cover 80 percent of their losses,” he explained. “Now the market has stabilised, whatever you sell it for would be greater than what would it have been when you were given the loss-share agreement.”

Despite the strengthening US real estate market, however, investors in loss-share assets could benefit from a less competitive landscape. Fewer firms, after all, are bidding on distressed US bank assets than during the height of the FDIC’s structured transaction sales. According to one GP, when the FDIC began executing structured transactions in 2009, there were approximately 25 bidders on those deals. Now, that number has dropped to about five.

With distressed debt portfolios costing as much as $500,000 to underwrite and requiring significant infrastructure and teams to both evaluate and manage, many former contenders now have dropped out of the running. “In this business, you have to be committed to do it,” the GP said.