Goldman Sachs Targets Small Loans in Yield Hunt: Credit MarketsSridhar Natarajan
A Goldman Sachs Group Inc. unit is joining firms from Ares Capital Corp. to Fifth Street Finance Corp. in raising about $2 billion to lend to companies unable to tap public markets as investors seek to extract high yields.
Goldman Sachs Liberty Harbor Capital LLC, which is organized as a so-called business-development company and primarily lends to companies earning less than $75 million, plans to raise money in an initial public offering, according to a March 29 regulatory filing. Last week, New York-based Ares Capital, the largest BDC, raised about $290 million by selling shares, while Garrison Capital Inc. completed its IPO. Fifth Street Finance said it may raise $1 billion.
The flurry underscores the lengths investors are willing to go to in order to generate returns as the Federal Reserve keeps benchmark interest rates near zero for a fifth year. While the debt the BDCs are buying generate yields of 10 percent or more, it doesn’t typically trade.
“Banks have largely abandoned the field in direct lending to the mid-market and it’s been taken over in the last few years by BDCs and private funds,” Nicholas Marshi, the chief investment officer at Southland Capital Management, said in a telephone interview from Santa Monica, California. Marshi manages funds that invest in BDCs.
There are “significant opportunities” for lenders as about $400 billion in loans from smaller, private firms mature in the next four years, according to a report from investment bank Keefe, Bruyette & Woods Inc.
BDCs, which typically pay out most of their earnings as dividends and get tax exemptions, usually lend to private companies and hold the debt to maturity. The leverage at the firms cannot exceed a debt to equity ratio of 1.
“Think of the BDCs as the intermediary between banks and non-investment grade credit,” Leonard Tannenbaum, the chief executive officer of Fifth Street Finance, said in a telephone interview. “By issuing bonds and raising equity, we are able to increase our holding size.”
Fifth Street Finance said in an April 5 regulatory filing that it may raise as much as $1 billion to make investments in small and mid-sized companies.
The Federal Deposit Insurance Corp.’s revised assessment guidelines may limit the attractiveness of such loans to some banks, providing less competition for BDCs, Jonathan Bock, an analyst at Wells Fargo & Co. wrote in a March 26 report.
Bock cut his outlook for the sector to “market weight,” citing new investment yields near historic lows.
Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. fell. The Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, declined 0.9 basis points to a mid-price of 86.03 as of 11:20 a.m. in New York, according to prices compiled by Bloomberg.
The index typically falls as investor confidence improves and rises as it deteriorates. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
The U.S. two-year interest-rate swap spread, a measure of debt market stress, increased 0.18 basis point to 15 basis points as of 11:24 a.m. in New York. The gauge narrows when investors favor assets such as company debentures and widens when they seek the perceived safety of government securities.
Bonds of Fairfield, Connecticut-based General Electric Co. are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 5.6 percent of the volume of dealer trades of $1 million or more as of 11:27 a.m. in New York, according Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Business-development companies are closed-end mutual funds that were created after legislators in 1980 amended the Investment Company Act of 1940 to facilitate private investment.
Allied Capital Corp., one of the earliest publicly traded BDC, was accused by David Einhorn, the founder of the hedge fund Greenlight Capital, of making fraudulent loans. In March 2009, its auditors expressed doubt about the company’s ability to continue and in October of that year it was purchased by Ares Capital for $648 million in stock.
Einhorn’s Greenlight is the fourth-biggest holder of Fifth Street Finance, Bloomberg data show.
Publicly listed BDCs have more than doubled since 2009 to more than 35, according to Southland’s Marshi. Sales of junk-rated debt funds known as non-traded BDCs doubled to a record $2.8 billion last year, according to MTS Research Advisors.
The companies, which operate with an average leverage of about 0.6 times, according to an April report from Keefe, Bruyette & Woods analysts Troy Ward and Greg Mason, use the money from borrowings and equity offerings to lend to smaller firms. BDC may also make equity investments.
Ares Capital held senior debt of about $3.6 billion, compared with about $669 million of preferred and other equity securities of its $5.8 billion investments, according to its Feb. 27 regulatory filing. The company has a market capitalization of $4.7 billion, up from about $500 million four years ago, Bloomberg data show.
A new proposed legislation for BDCs seeks to increase the maximum allowable debt to two times total equity, Marshi said. “They could choose to borrow more money, which unfortunately makes the structure more riskier,” he said.
Interest in BDCs is rising just as Fed officials express concern that its asset purchase program and low interest rate policy is making investors search out ever-riskier deals to generate returns.
Yields on speculative-grade bonds fell to a record low of 6.38 percent on March 28, Bank of America Merrill Lynch index data show. The average yield on middle-market loans has dropped to 6.83 percent from 11.55 percent at the end of 2009, according to S&P’s Capital IQ Leveraged Commentary & Data.
Goldman Sachs’s Liberty Harbor unit was funded by the parent company in November and has since invested about $73 million in eight companies, according to its March 29 filing. About 31 percent of that is in first-lien debt, and 60 percent in second-lien borrowings.
Consolidation of regional banks into money-center banks has reduced the focus on middle-market lending, diminishing the availability of credit and resulting in higher interest rates for the companies, according to the filing. Andrea Raphael, a spokeswoman at Goldman Sachs, declined to comment on how much may be raised in the IPO.
Deposits at U.S. banks exceed loans by an unprecedented $2 trillion, Bloomberg data show. This is happening even as U.S. commercial bank assets loans have climbed to a four-year high of $1.5 trillion, according to data from the Fed.
“With an entrant like Goldman Sachs in the market, it obviously raises awareness,” Troy Ward, an analyst at Keefe, Bruyette & Woods, said in a telephone interview. “If you think about the size of the middle market, the assets that BDCs have available to invest is just a drop in the bucket.”
The annualized average credit losses in BDCs since 2006 has been less than 1 percent, with recovery rates higher than larger, more broadly distributed loans, according to Ward. Last year, BDCs raised $3.9 billion in IPOs and follow-on offerings, the most since 2007, according to Ward. More than $1 billion in debt was raised in about 15 issues, the most on record.
“It’s a market that has just opened up,” Ward said about the firms issuing debt. “Before 2012, nobody had really tried, and within a few months these companies were able to tap this market and cut rates.”
Ares, which first came to the market with a $143 million offering, paid a 7 percent coupon on its 10-year preferred notes. When it returned to borrow more money in September, the firm paid 5.88 percent on its $175 million 10-year preferred debt. That compared with a 0.7 percent reduction on yields in the Bank of America Merrill Lynch Index for similarly-rated debt.
“Everything suggests that there will be very fast growth in this sector,” Marshi said. “You have to assume 20 percent annual growth until the next recession.”