Important Terms
Middle Market: Refers to the mid-sized companies that fall between small businesses and the largest corporations. They are significant in number but often find it challenging to raise capital through public markets due to their size.
High Yield Bond: A type of debt instrument that offers higher returns due to higher risk associated with borrowers that are considered less credit-worthy. These bonds are appealing to investors looking for higher income through interest rates.
Issue Size: The total amount of money the company intends to raise through the issuance of bonds. Smaller companies often struggle with meeting the minimum issue sizes required for traditional bond issuance, which were around $125 to $150 million(in ~2000s and might be much more now).
Ratings Process: A method by which credit rating agencies assess the creditworthiness of an issuer. The process can be costly and time-consuming, which makes it less accessible for smaller companies.
Syndicate: Refers to a group of banks or financial institutions that work together to issue and distribute a bond. This process can also involve significant costs and complexities, adding further barriers to entry for middle-market companies.
Mezzanine finance: A type of private credit that serves as a hybrid of debt and equity financing. It typically takes a junior position in the capital structure behind senior bank loans but ahead of equity, offering both loan repayment and rights to conversion into equity if the loan is not paid back on time and in full.
Dodd-Frank Act: Passed in 2010 in response to the financial crisis, this legislation aimed to increase government oversight of the financial industry and decrease the risk of future financial crises. It imposed stricter regulations on banks and financial institutions.
First Lien and Unitranche Private Credit:
First Lien: This type of credit refers to loans or debt that take precedence over other debts in case of a default; they are secured by the assets of the borrower.
Unitranche Private Credit: A combination of senior and junior debt (or subordinated debt) into a single loan. This blend simplifies the capital structure and provides a quicker, more streamlined lending process.
Second Lien: This is a type of debt that ranks below first liens in the event of a default and is therefore riskier.
Syndicated Bond or Loan Market: This market involves multiple lenders, usually banks or financial institutions, that pool together to provide substantial loans to single borrowers. The loans or bonds can be traded on secondary markets.
Asset-Backed Finance: A type of lending where the borrower's assets are used as collateral for the loan. This type of financing is often used by companies with significant assets but limited access to traditional credit markets. These assets could be various types of property, including but not limited to real estate, vehicles, equipment, or even financial assets like receivables.
This type of financing is crucial for businesses that need to leverage their existing assets for expansion or operational purposes and for investors or lenders looking for secured investment opportunities. It also includes more complex financial structures like asset-backed securities, where pools of assets are packaged and sold to investors as bonds or notes.
Opportunistic Credit: This type of credit is extended in situations where the borrower may be facing financial difficulties, often with higher returns for the lender due to increased risk.
LBOs (Leveraged Buyouts): These are acquisitions where a significant portion of the purchase price is financed through borrowing. The assets of the company being acquired usually serve as collateral for the loans.
Secured Overnight Financing Rate (SOFR): is a benchmark interest rate used primarily for loans and financial contracts, and it’s gradually replacing the older LIBOR (London Interbank Offered Rate). Unlike LIBOR, which was based on estimates from banks about how much they would charge each other for unsecured loans, SOFR is calculated based on real transactions that involve borrowing cash overnight, secured by U.S. Treasury securities. This makes SOFR more transparent and less susceptible to manipulation than LIBOR, which relied on subjective estimates.
Maturities: Refers to the expiration or due date of a financial instrument. In the context of loans, it's when the principal (or remaining balance) of the loan is due to be paid.
LIBOR vs. SOFR with an Example Imagine a company takes out a large loan with an interest rate based on LIBOR. If the loan agreement specifies a rate of LIBOR + 2%, and LIBOR is currently at 1%, then the company would pay an interest rate of 3% (1% LIBOR + 2%) on the loan. However, since LIBOR rates were often based on bank estimates, they could fluctuate unexpectedly based on market perceptions or even be manipulated. Now, let’s look at SOFR. With SOFR, suppose the company takes out a similar loan with a rate of SOFR + 2%. If SOFR, which reflects actual overnight borrowing costs secured by U.S. Treasuries, is currently at 0.5%, the interest rate would be 2.5% (0.5% SOFR + 2%). SOFR is considered more stable and accurate because it’s grounded in real transactions rather than estimates. SOFR’s reliance on real, secured overnight transactions provides a more reliable and consistent benchmark, which has led to its growing adoption in financial markets as a replacement for LIBOR.
Rescue credit: also known as distress financing or rescue financing, is a type of financial support provided to companies that are experiencing significant financial difficulties but are still considered viable in the long term. This kind of credit is often used to help a company avoid bankruptcy, restructure its debts, or go through a financial turnaround.
BDC (Business Development Company) Products: These are vehicles that allow individual investors to participate in private credit investments typically available only to larger institutional investors. The BDCs operate with a "best ideas" strategy, choosing investments based on the most promising opportunities across both public and private markets, depending on market conditions.
Traditional Private Credit Funds: These funds generally focus on providing loans to mid-to-large-sized companies. Oak Tree's private credit team sources these deals, with a strong emphasis on rigorous sector-specific analysis.
CLOs (Collateralized Loan Obligations): These are structured finance vehicles that pool together cash flow-generating assets (like loans) and then issue tranches of securities backed by these assets. The CLOs benefit from diversification across many different loans, and investors in CLOs can choose tranches that match their risk tolerance.
Large Cap First Lien Sponsor Lending: This is a strategy focusing on large, secure loans to big businesses, generally worth at least a billion dollars or having significant earnings before interest, taxes, depreciation, and amortization (EBITDA). These loans offer what Oak Tree sees as excellent risk-adjusted returns due to their secured status and significant equity cushion provided by private equity sponsors.
Rescue Lending and Mezzanine Finance: These are more specialized financing options. Rescue lending provides critical support to companies in distress, aiming to stabilize them until they can return to financial health. Mezzanine finance is typically a form of junior debt that sits between senior debt and equity, used primarily in the acquisition of companies.
Sector-Specific Funds: For instance, life sciences lending, which targets companies in the biotechnology, pharmaceutical, and healthcare equipment sectors. These loans are structured around the unique needs and risks of this industry, often contingent on regulatory milestones like FDA approval.
Leveraged Buyouts (LBO): an acquisition of a company where the acquiring company uses large quantities of outside capital, often debt, to meet the cost of the acquisition.
Direct Lending: This is the largest segment of private credit, often comprising over half the market. Direct lending involves providing financing directly to companies, typically those backed by private equity sponsors. These loans are similar to syndicated term loans and are often based on earnings before interest, taxes, depreciation, and amortization (EBITDA) or adjusted revenue run rate (ARR). Direct lenders compete directly with the syndicated loan market, typically offering financing for acquisitions or growth initiatives.
Asset-Based Finance (ABF): This type of lending is secured by assets such as inventory, receivables, or other tangible assets. It includes specific subtypes like venture debt, which is often provided to startups, and NAV (Net Asset Value) financing, which has grown popular particularly in life sciences.
Private Institutional Drawdown Funds: These are similar to private equity funds. Institutional investors commit capital which is then drawn down as investment opportunities arise. These funds usually have a defined life cycle with potential for extension and are designed for institutional investors.
Business Development Companies (BDCs): BDCs can be traded on public stock exchanges (traded BDCs) or not traded (non-traded BDCs). Non-traded BDCs have been particularly popular due to their accessibility to a broader audience, including retail investors. They do not involve capital calls, and investors commit capital upfront. BDCs are required to distribute a significant portion of their income to shareholders and can offer regular income through dividends.
Exchange-Traded Funds (ETFs) of BDCs: These ETFs invest in a range of BDCs, providing diversification within the private credit space. Some ETFs are market cap-weighted, while others are actively managed. They offer liquidity and are accessible through standard investing apps, making them a convenient option for individual investors.
ETFs Composed of CLO (Collateralized Loan Obligation) Tranches: These ETFs invest in various tranches of CLOs, ranging from the safest (AAA-rated) to more risky (double B-rated) tranches. This allows investors to gain exposure to syndicated bank loans that are repackaged as CLOs, offering floating rate returns similar to those of private credit loans but with a structure that diversifies risk.
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