August 6, 2024 - Leverage is a tool that can enable asset managers to increase investment capacity and improve returns without altering their investment strategy or sacrificing asset quality. Despite this utility, leverage is often associated with magnified gains or losses that stem from financing investments with minimal cash outlays and high levels of mark-to-market debt. Certainly, there are nonbank borrowers that use this type of leverage to generate excess returns and are impacted by the day-to-day volatility of their investments.

It is little wonder then that policymakers and regulators are constantly focused on understanding leverage in the financial system. However, when it comes to financial stability, the source of leverage is as important as the headline leverage level. The truth is that leverage comes in many forms with different levels of risk and can be used responsibly to enhance returns.

In private corporate credit (PCC), certain data indicate that headline leverage is modest. Moreover, its structure is fit for purpose. For one, managers look to match the duration of their financing with the term of their fund. Additionally, the most common sources of leverage in PCC (e.g., credit facilities and collateralized loan obligations (CLOs)), are not vulnerable to market fluctuations or forced selling. (For clarification, the leverage discussed in this article refers to leverage at the fund level (i.e., the manager’s source of capital) rather than at the asset level (i.e., the capital structure of portfolio companies)).

In recent regulatory publications – including the Federal Reserve’s Financial Stability Report and the International Monetary Fund’s Global Financial Stability Report – regulators have concluded that PCC does not currently pose a threat to financial stability. Still, they flag that their lack of visibility into leverage in PCC funds is seen as a risk in and of itself as it hinders their efforts to monitor vulnerabilities in the market. There are two points that should qualm this concern: 1) Business Development Companies (BDCs), a meaningful holder of PCC, publicly report on their leverage levels, which continue to be modest and 2) the types of leverage used in PCC is generally not subject to mark-to-market volatility or forced selling (i.e., immediate liquidity needs).

Indeed, fund level leverage at BDCs is carefully managed. While BDCs may maintain leverage at the statutory cap of 2x contingent upon approval from their boards or shareholders, public filings show that leverage at BDCs averages around 1x, according to LSEG’s BDC Collateral. Looking past BDCs, it is important to note that not all private funds that invest in PCC use leverage. Anecdotally, however, where leverage is used – typically to satisfy investor preferences – levels are similar to those of BDCs, ranging from 1x to 1.2x. Though the BDC data is instructive, regulators may be reluctant to extrapolate it to the broader market without evidence.

While there may be consistency in the quantum of leverage across private funds and ’40 Act funds that invest in PCC, the leverage sources vary. Regardless of their structure, these sources have a critical feature in common: stability. Below we provide an overview of these types of leverage. (The descriptions that follow have been adapted from Dechert’s Financing Your Private Debt Platform and Sidley’s Developments in Fund Leverage: NAV Financing and Co-Invest Facilities.)

Asset-based loan (ABL). ABLs advance credit against a borrower’s portfolio of investments based on the value and classification of each eligible investment held. The advance rate is the amount of credit that a lender will extend against the value of a particular asset. The advance rate determines the borrowing base, or the total amount of credit available under the facility. The borrowing base is periodically redetermined based on changes in certain credit metrics of the underlying collateral. While some ABLs are extended at the fund level, most ABLs sit at the SPV level, where the SPV is a wholly owned subsidiary of a parent fund. SPV-level facilities benefit from a bankruptcy remote structure, providing recourse only to the portfolio of assets the SPV holds. They are commonly subject to collateral consent rights by the lender.

Securitization. A securitization involves the pooling of assets and the tranching of risk.

• CLO. CLOs are private funds that raise money by securitizing a pool of loans into varying tranches of investment-grade and sub investment-grade secured notes and unrated subordinated notes, preferred equity or other first loss positions. Private funds that invest in PCC, as well as ’40 Act Funds, utilize CLOs as a financing mechanism (as opposed to arbitrage vehicles, which aim to capture the spread between returns on assets and costs of liabilities for equity investors). Like their broadly syndicated counterparts, private credit CLOs (PCLOs) are structured to provide protections and credit ratings that benefit debt investors. CLOs may be used as a substitute to an ABL.

• ABS-style. These transactions are similar to CLOs and offer managers of private funds better flexibility to finance loans that are viewed as niche products relative to regular-way PCC loans. These structures have been utilized to finance loans to venture- and/or sponsor-backed borrowers in sectors that are considered higher risk than traditional loans backing private equity-sponsored buyouts. They are a preferred method of financing recurring revenue loans.
  
  
• Rated feeder note. Thesenotesareissued by a feeder fund in lieu of a traditional equity capital commitment and rated by a credit ratings agency. PCC managers offering interests in their funds to domestic and foreign insurance companies will often structure a portion of these offerings as rated notes. As rated debt, the notes receive favorable risk-based capital treatment by the National Association of Insurance Commissioners, the regulatory body for the insurance industry.

Subscription (sub) line. A subscription line uses the capital commitments of investors in a fund as collateral. Sub facilities are often used in the ramp up stage of funds to bridge the period necessary to call capital for investments. Once the fund has achieved a material level of diversification, managers may use a hybrid facility that includes investor capital commitments and portfolio investments of the fund in the borrowing base for longer-term needs.  

Net asset value (NAV) line. ANAV (i.e., asset value minus liabilities) financing is based on the value of the fund’s underlying investments. A NAV financing is focused on a loan to value (LTV) test, which requires that the amount of debt drawn under the facility does not exceed a given percentage of the net asset value of the fund’s underlying investments. NAV lines are used in the late stages of the fund’s lifecycle, when the fund is fully ramped up.

BDC bond. Theseunsecured debt securities are commonly issued by BDCs (subject to market conditions) to diversify equity and bank debt financing. They may be issued in a public offering or private placement.

Over the coming weeks, we will take a closer look at these forms of financing and their attributes.