By Randy Schwimmer
One of the enduring fictions about middle market loans relates to their tradability. Smaller loans, the theory goes, are priced at a premium because there are fewer ready buyers. Unlike their broadly syndicated cousins, loans below $250 million have no effective secondary market. That’s the idea, anyway.
Large loans are bought by institutional investors, mainly CLOs, insurance companies and credit funds. These buyers need loans to be rated by two rating agencies and to have tranches of at least $250 million, so that trading among holders is relatively efficient.
The agent bank in institutional loans has an important role: it makes a market in their primary issuance. That means matching buyers and sellers of new loans.
When deal terms settle and allocations are determined and communicated to each lender, the loan becomes free to trade “at the break”. A big share of early trades involves accounts settling around their preferred hold levels.
Other bank loan desks can jump into the secondary market and publicise bid/ask spreads based on recent activity. These lists purport to show at what price a buyer will buy or sell a loan, and how much is available at that price. However, these “axes” are more promotion than valuation. Say you want to buy $4 million of XYZ Co. offered at 99.5. You will likely be told: “Well, that was the last trade. This loan is well put away [hard to get]. But I can probably get you $2 million at 101.” So much for liquidity.
Large cap loan buyers are fond of saying: “I like liquid loans because I can sell them if I need to.” The problem is that negative news spreads fast, so everyone heads for the exits at once. In December 2009, the average flow-name price dropped to 67. When you really need big loan liquidity, it’s not there.
Middle market loans don’t have the same liquidity features as large loans. They are generated by buy-and-hold lenders who have no intention of trading them. Also, they aren’t typically rated so don’t fit into CLOs. Finally, if a participant opts to sell, the likely buyers are the existing lenders. Going outside that group to find buyers for a middle market loan is comparable to a house-to-house search.
But this doesn’t mean middle market loans are less liquid or have less value. One loan pro explained it to us this way. “If I own the credit and like it,” he said, “you can’t pry it out of my cold, lifeless hands, no matter how much you offer. Originating these loans takes more time, energy and underwriting effort than broadly syndicated loans.” And what if the company’s performance suffers? “I won’t be able to sell it at any reasonable price,” he admitted. “So I might as well hold it and work it out.”
That, in essence, is the liquidity paradox. Large, liquid loans will swing in value with the mood of the market or on issuer-specific news. You may get a price in a downdraft, but you won’t like it. Middle market loans don’t care what the Dow is doing. That tempers volatility and, in the long run, provides greater predictability.
Veteran institutional investors have a tough time accepting the lack of ready trading in the middle market as being beneficial. Old habits die hard. But one thing is certain: a lot of capital has flowed into the asset class this year. And that’s at a time when retail cash is exiting large cap funds in droves.
Randy Schwimmer is senior managing director and head of origination and capital markets at Churchill Asset Management, a credit asset management firm affiliated with TIAA-CREF Asset Management. He is also founder and publisher of The Lead Left (theleadleft.com), a weekly newsletter about trends and deals in the capital markets.
This column first appeared in the weekly newsletter of Creditflux, a leading global information source for the credit trading and investment market.