Daniel Smith is managing partner and head of debt investments at RBC Capital Markets. Smith discusses with Loan Market Week RBC's approach, second-lien structures and the development of the syndicated loan market to a fully fledged capital market.
LMW: Can you describe RBC Capital's approach to the loan market?
RBC is highly credit focused and defensive. We like to invest in situations where first and foremost we believe the credit is going to perform, and secondly in the event we are wrong and the credit is not what we thought it was, then we have a backdoor way to get our money back through either enterprise value or asset value, given our position in the capital structure.
When we're considering subordinated investments like mezzanine debt, we have to put on a different hat, i.e. take a bit more of an equity approach given that there is a different risk and reward dynamic. But when it comes to loans, we make sure our position is as bulletproof as possible. Knowingly risking your principal in above average-risk credits for a spread of a few hundred basis points over LIBOR does not get it done.
LMW: What distinguishes RBC from other participants in the loan market?
Aside from the experience and quality of our team, I would have to say it is our middle-market capabilities. Our structures and our funds will typically have exposure across the company size spectrum--broadly syndicated large transactions all the way down into the middle middle-market loans.
Additionally, our debt funds group is affiliated with two active middle-market leveraged finance origination businesses, which provides us with a unique perspective into the leveraged finance markets and proprietary investment opportunities. The principal finance business is an investment business that is focused on generating investment opportunities in mezzanine debt, equity co-investments and senior secured loans in smaller transactions. The leveraged finance business is a more traditional investment banking business that is focused on financial sponsors, but has a strong orientation towards middle-market transactions.
While these businesses provide us with investment opportunities directly, equally as important, it gives us a very strong pipeline into the middle-market. Generally less than 20% of the mid-market assets we invest in will have been originated by these businesses--where they will have acted in a lead role. The other 85% comes from other firms in the middle-market and we get those opportunities because the sponsors and other financing providers know that we collectively are consistently active participants in this area of the market and have been for a long time.
In addition to the leveraged finance businesses, we have a group within RBC Capital Partners, which is currently marketing a fund-of-funds which will invest in private equity funds. This business helps to solidify our presence in the leveraged finance world and enhance relationships with LPs and financial sponsors. Again, a big part of what makes us different and a better investor is that we benefit from seeing the leveraged finance world from all sides. On top of our fundamental credit analysis, we understand what is driving the equity in these leveraged transactions and what is being asked of the financing providers. All of which gives us a good ability to appropriately understand where risks are and where you should be positioned in any particular capital structure given the company or the industry.
In summary, we have a 360 degree view of the leveraged finance business as an investor in private equity funds, as a provider of financing as well as an investor in the products that come out of leveraged transactions. It is worth noting that the people making the investment decisions on behalf of investors in the funds are a totally separate team. We have invested in the resources to ensure that the potential conflicts are minimized and the integrity of our investment process is very high.
LMW: How has the loan market changed in the last year and what have been the positives and negatives?
The broadly syndicated loan market is now truly a capital market. Liquidity is good, the size of the market is large--bigger than the high yield bond market--and the number of participants both on the dealer/market-making side as well as on the investor side is significant. With everyone's expectations that at some point interest rates will rise, the floating rate nature of the loan product has also generated a lot of interest.
The negative is that clearly spreads have come in dramatically and one of the struggles, given that broadly syndicated loans have become a capital market, is that the asset class is trying to find a balance with respect to some of the structural characteristics. At the moment everything is in favor of the borrower because the terms/structure of the loans still have a lot of the features that existed back when the market was dominated by banks and was less liquid.
With the growth of the institutional investor and resulting liquidity, borrowers and agents are capitalizing on the current demand and repricing loans four, five, six months after they have been issued with no change in the underlying credit/risk. I understand the grid concept, where if a company's leverage comes down you would improve the pricing to their benefit because you are taking less risk, but that is not what is happening.
While I cannot blame borrowers for taking advantage of the current situation, they should expect that when the capital flows slow investors will return the favor. When flows reverse and borrowers need to amend their credit agreements or get a waiver, investors will take their pound of flesh and demand that pricing be increased. In the end, the cost of capital associated with bank debt will be highly volatile, which will make it a less attractive corporate finance tool and that does not help anyone.
LMW: Have the banks done enough to protect investors in the last year from spread compression/repayments and is it their role to protect investors in this way?
The investors have to stand up for themselves. Agents are in the business of getting the best execution for the borrower and structuring the deal so they can sell it, distribute the risk and earn a fee. If investors are willing to buy under the current terms, the agents will sell it to them. It's up to investors to push back and start to say this does not work. I think that there should ultimately be some consideration given to investors such as a short non-call period and/or some form of call premium that allows for more stability, but nothing too offensive.
Clearly if you make the call premium too onerous, the loan product will lose its appeal to the borrower and that will not benefit anyone either because borrowers won't use the product. There is a happy medium, but right now there is so much cash waiting to be invested that people are not willing to pass up a transaction to make a point. These are long-term issues that will get sorted out over a cycle or two.
This is a big contrast to the middle-market, which is not a capital market. The middle market has limited liquidity and as a result you don't have many of these opportunistic repricings. It's much stickier. The inclusion of middle market loans in our portfolios has been a big help in that regard over the last six to nine months.
LMW: What is RBC's view on second-lien loans?
On a very limited basis have we participated in second-lien loans. We have done so only where we think it's still a reasonable capital structure, and we are giving up little in the way of downside protection for a significant increase in return. The second-lien structure, was clearly designed to favor the borrower and or equity in a transaction because it helps them brings down their weighted-average cost of capital. A typical transaction that might have been 2.5 times leverage senior secured debt and another turn of subordinated debt has now evolved into something where there is a first lien that is 2.5 times leverage and a half turn plus of second-lien. Issuers are getting the same amount or more of leverage but at a much lower cost.
Not only are the second-lien guys taking a lower return than what subordinated debt or mezzanine would have required in the old structure, but the senior secured lender is making a concession in the form of subordination (diluting their secured position). Clearly second-lien is structurally and legally not as subordinated as true subordinated debt. While second-lien is behind first-lien in preference of liquidation, secondliens are potentially at the table when it comes to other kinds of negotiations. If it was subordinated debt they would not be there. It's a potential dilution overall to these capital structures.
LMW: RBC has indicated it would like to leverage its infrastructure to invest in other asset classes. What areas do you find appealing?
We look at what our core competencies are and hope to build on them. Knowledge of credit is a primary asset for us and core to what we do. Understanding structures and managing structured portfolios is another. You would not see us managing mortgage-backed securities from this platform without adding a new set of distinct resources, but you might see us when the time/opportunities presents itself moving into say synthetic investment grade (credit default swaps) or a related asset classes. Before credit spreads collapsed, we looked closely at credit default swaps and found it to have some interesting attributes as an asset.
Investing on behalf of a CDO takes a very disciplined approach and specific resources. In my opinion, having become proficient at managing CDOs and having managed other types of less restrictive portfolios (mutual funds), it is easier to go from CDOs to then managing some other types of investment vehicles than the other way around. I am confident we can go from a CDO perspective to different pools of capital like managing separate accounts or pooled funds for bank loans. With that said, CDOs will continue to be a staple product for us regardless of other tangents that we may pursue.