- September 1, 2018: Vol. 5, Number 8

Willie Sutton would be eating his heart out: If around today, the notorious bank robber would find a dizzying array of money-rich targets, thanks to a proliferation of debt funds

by Steve Bergsman

Back in 2012, Mesa West Capital was one of the country’s top five nonbank lenders. Five years later, it was acquired by Morgan Stanley Investment Management. Berkshire Capital Securities ushered the deal through to completion. “This is an example where an independent commercial real estate debt manager partnered with a larger institution to secure global clients,” observes Ted Gooden, a Berkshire Capital managing director. It also brought Morgan Stanley into the nonbank lending business.

The Morgan Stanley deal is the most prominent in this sector, but “there will be others,” Gooden adds.

It has been an unbelievably glorious 10 years for nonbank lenders and debt funds, supported by individual and institutional investors. Literally rising from the ashes of the financial crisis, the private debt market has completely submerged bank lending in almost all economic sectors. The reasons are obvious: The financial crisis scorched bank balance sheets, curtailing banks’ ability to lend capital, and then during the recovery, new regulations slapped additional restrictions on lending. The banks have never regained their mojo. Private credit stepped into the void.

The worry at the moment is not that the economy will suddenly flip, thus wounding investors, but the opposite: The good times have gotten too good, the debt-fund market could be getting crowded, yields will compress and even veteran independent companies will need to align with bigger firms to sustain the momentum.

According to Preqin, a London-based financial research company, as of first quarter 2018, 350 private debt funds were in the global market seeking an aggregate $160 billion — 66 more funds and 30 percent more capital compared with early 2017. On a positive note, Preqin also reported 98 percent of institutional investors planned to increase or maintain private debt allocations in the long term.

One of the companies raising funds is Basis Investment Group, which has created a “several-hundred-million-dollar fund” for structured financing lending, including bridge, mezzanine and preferred-equity funding. The company has had a commercial mortgage–backed securities platform since 2010 and has become an approved Freddie Mac small-business lender. Basis expects 2018 will be busier than 2017.

“This is our first fund,” says Mark Bhasin, a Basis Investment vice president. “We can find enough transactions for this, as we are doing smaller deals with a minimum bridge-loan amount of $10 million. There are bigger funds out there chasing larger check sizes; we will go smaller, which is less institutional. We have a lot of repeat business; and this point in the cycle, you want to tap that repeat business as opposed to having to form new relationships.”

Basis Investment was founded in 2009, at the tail end of the financial crisis. At the time, the nonbank debt world was exploding, but a lot of the lenders were foreign capital providers. It was a fortuitous time for U.S. companies to enter the business. Basis Investment did well as the United States eased into a recovery period after the financial crisis and is now into the second-longest economic expansion in U.S. history, at more than 110 months. Now the economy is either at peak or near peak.

“We are long into the cycle,” says Bhasin. “When you are nine years into an expansion, everything gets competitive, whether you are in the debt, equity or service business. It’s much more challenging to form relationships with borrowers. It was much easier back in 2010 and 2011.”

In addition, Bhasin reports yields have compressed as other investors have come into the space. Bridge rates today are in the mid-to-high single digits; mezzanine and preferred equity lending rates are still 9 percent to 13 percent. Although good, Bhasin says these rates were higher five years ago, before new capital providers flooded into the space.

One of those newcomers is Pender Capital, founded by Cory Johnson three years ago. Since then, it has raised nearly $100 million for the commercial real estate space. Unlike Basis Investment, Pender Capital is oriented toward fee-based advisers, with about 90 percent to 95 percent of its monies raised through the registered investment adviser market. It avoids the institutional competition by lending in the $1 million to $10 million credit space — much too small for the big lenders. It also stays out of the major first-tier markets, preferring second-tier metros where “we can generate a lot of deal flow and be selective on the credits we extend,” says Johnson.

That being said, Pender Capital “is definitely seeing more regional competition than we were dealing with a year or two ago,” notes Johnson. “We offer more of a true bridge product, which, on the nonbanking side of the table, charges on average about 150 basis points more than traditional banks, which is why it has become a competitive segment of nonbanking commercial real estate lending.”

Johnson will not say what returns are for bridge loans, but he does indicate the goal is getting harder to meet.

“We have to price an extra deal or two to fund at the same historic level that we have been able to achieve in the past,” says Johnson. “What really concerns me more than anything else is when we lose a deal not due to pricing, but due to another lender that has advanced more money to a borrower who may not warrant it at this stage of the project. What I mean by that is, we target 60 percent to 65 percent loan-to-value. When we lose a deal where someone extended 80 percent LTV, those are the deals tough to swallow. They are debt players, but they are taking equity-type risk for a debt-type return; it doesn’t make a whole lot of sense.”

As noted, the changing lending environment has ushered in a new level of cooperation between large and even larger capital providers and asset managers. As an example, in fourth quarter 2017, two sets of major financial companies teamed up to cut a swath through the private credit space.

First, OppenheimerFunds and The Carlyle Group announced a joint venture to provide global private credit opportunities for high-net-worth investors. In June, the partnership launched the OFI Carlyle Private Credit Fund, which will allocate assets across a range of credit strategies, including direct lending and structured credit to companies globally. It will do select real estate transactions because Carlyle has expertise in that area, but it is not creating a dedicated commercial real estate sleeve.

“This space has been picking up in terms of numbers of new managers,” says Kamal Bhatia, co-head of the joint venture and head of investment solutions for OppenheimerFunds. “Even hedge fund managers are entering the space.”

Nevertheless, Bhatia is optimistic: “As more baby boomers come into the market, the need for quality income solutions is only going to increase. We are entering a period where the private market will be a bigger part of portfolio allocations. We are in the early innings, particularly in the fixed-income space. The next two years, you will see a lot of institutional managers coming into this part of the wealth management space.”

The second high-profile partnership was between FS Investments and KKR & Co. to form an $18 billion middle-market, alternative-lending platform.

“With $18 billion in assets invested across six vehicles, the partnership manages the country’s largest business development company [BDC] platform,” says Marc Yaklofsky, a senior vice president at FS Investments.

The middle market serves as the engine that drives the U.S. economy, and an overwhelming majority of those companies are privately held, so these firms may not have access to the public markets to grow their businesses.

“Historically, banks were their capital lifeblood, but coming out of the financial crisis, banks significantly pulled back on commitments to this space,” says Yaklofsky. “It created an opportunity for nonbank lenders to be that source of capital, and the BDC structure is designed to allow individual investors to invest in the debt of private, U.S. middle-market companies.”

FS Investments entered into this agreement because as the BDC space evolves, “size, scale and diversity of investment opportunities will be critically important,” explains Yaklofsky.

Another avenue capital providers are using to remain successful is specialization. Northern Shipping Funds raised $505 million for its newest closed-end investment, Northern Shipping Fund III, which will be used to finance small- to mid-size companies in the shipping and oil service industries.

The absence of banks supporting this industry creates opportunities for alternative capital providers, says Sean Durkin, president of Northern Shipping Funds. “Banks are withdrawing. Asset-based lending is declining, whether it is shipping, agriculture, commodities, real estate — a lot of industries face a pullback by the banks.”

Durkin said he has not seen a surge in new capital providers entering his market. “The industries targeted by most alternative lenders have a lower barrier to entry because these lenders are generalists,” he explains. “If you are going to come into this space, you need specific knowledge of the industry, assets and the counter-parties.”

As with other funds, most of Northern Shipping’s investors are looking for preservation of capital, a physical asset that protects the downside, and an absolute return significantly greater than what they could earn in the high-yield bond market.

“Privately held investment companies have done an effective job of being responsive to borrower needs,” explains Gooden of Berkshire Capital, “whereas banks have become less aligned.” He cautions, however, “although deal activity remains high, market share has been harder for some groups because of all the new entrants.”

That usually means some capital providers will depart the business or get bigger quickly — and that is a different kind of deal making.

Steve Bergsman is a freelance writer based in Mesa, Ariz.

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