Investors looking for higher yields having been turning to private credit, citing the diversification benefits of the asset class.
But the high yields on offer in direct lending, the largest segment of the private credit universe, can often come from competing with banks for loans to companies with relatively high leverage.
Sashi Nambiar, head of financial intermediaries and wealth, Asia at Muzinich & Co. says parallel lending can address this issue, with asset managers working in partnership with banks to lend on equal terms to high-quality companies.
“When you look at the direct lending space, private credit funds are typically competing with banks to lend to private equity sponsors,” Nambiar (pictured) said.
As this competition has heated up, particularly in the upper-middle market, there has been a notable tightening in loan margins and weakening of structural protections, with some deals being executed without any covenants. This leaves lenders exposed should borrowers run into financial difficulties.
Nambiar said: “Parallel lending is different because rather than competing with banks, we participate in a club deal alongside them.”
“These borrowers are typically important clients of banks, who want to maintain that close relationship and continue to be their lender of choice. But due to regulatory restrictions in terms of how much capital banks have to hold against loans, asset managers like us come into play.”
“The bank is a lot more comfortable working with us, because there is no conflict of interest. We are not going to be competing for all the other business a bank will have from a key client.”
In these types of agreements, the bank takes on a large part of the loan, which are senior-secured and first lien, and an asset manager participates alongside them on a pari-passu basis.
Nambiar said: “What we also see in these cases is because of the regulatory requirement, leverage (net debt-to-EBITDA) tends to be much lower, and they tend to have higher interest coverage.”
“Since the loans are of a higher quality with lower leverage, some investors have a perception that such strategies will offer lower returns, but last year the US dollar version of our evergreen parallel lending strategy returned just over 11% on a net basis and paid out almost 10%.”
He said parallel lending resonates with high net worth clients because they understand and like the fact that they are exposed to a strategy where both the bank and the manager are conducting their respective due diligence.
Liquidity and reinvestment risk
One issue some investors have with private credit is relative illiquidity versus public markets, but Nambiar says the use of amortising loans making regular payments can provide a natural form of liquidity.
“Most of the loans tend to be shorter duration, say, two to four years, and tend to be amortising,” he said.
“That means there is around 15%-20% of cash coming into the strategy every year, giving you a natural form of liquidity without the need to make extra provisions.”
Due to the fact that loans are typically floating rate, there is some level of reinvestment risk, but partnering with a bank provides better deal flow than competing with them, according to Nambiar.
“One of the benefits of partnering with banks is that you get quick access to a large potential pool of loans. This is great for us and ultimately our investors because it allows us to be very selective. We reject around 85% of loans we could participate in, and are able to get good terms on the loans that do end up in the strategy,” he said.
“We can afford to be choosy. Even the loans that are rejected are still to high quality companies, but we are rigorous in selecting loans with optimal terms for our investors. Capital preservation is a big selling point of the parallel lending story and careful asset selection plays a vital role in us achieving that.”
