After more than 36 years of existence, the London Interbank Offered Rate (LIBOR) was discontinued in July 2023 in favor of alternative references rates, such as SOFR (Secured Overnight Financing Rate). As mentioned in previous Alter Domus reports, we discussed the need to migrate away from LIBOR and provided updates on the transition as the cessation date grew closer.

Now that LIBOR is no longer published, we report on the impact it continues to have, albeit declining, in the U.S private debt market and address any lingering considerations.

Announcement of LIBOR’s future discontinuation in 2017 posed an intimidating feat, like an impending storm, as LIBOR was pegged to almost all contracts accounting for billions of dollars of debt. Six years later, though, market participants made it through the storm quite successfully.

Overall, the LIBOR transition was, as the AARC[1] puts it, “smooth and uneventful.”[2] Much of the success is attributed to the careful planning and coordination between agents, like Alter Domus. borrowers, lenders and financial regulators.

Moreover, as the June 30,2023 deadline approached, there was a predictable uptick in credit agreement amendments and triggering of existing ones. As reported by the LevFin Insights, amendments spiked in June, nearly totaling 300, representing almost 3 times the amount of amendments in May and April[3].

The same can be inferred with respect to the direct lending space, as we turn to publicly available BDC (Business Development Companies) data as a proxy. From a sample of 13 BDC’s registered with the SEC, representing over $33bn in portfolio valuations or about a quarter of the publicly traded BDC market, we observe from the 2023Q2 SEC filings that the average decrease in loans tied to LIBOR jumped to 27% during 2023Q2 from 10% in 2023Q1.

The graph and table that follow clearly illustrate the declining relevance of LIBOR and rising relevance of SOFR in the last four quarters – with SOFR beginning to equal and surpass LIBOR in Q1’23. Over the past 9 months, SOFR-pegged loans have gone from 28.5% of total floating loans to 75% for the loans in the underlying sample portfolios.

LIBOR Declines While SOFR Grows (sample of 13 BDCs)

Count of Floating-Rate Investments – Sample of 13 BDCs over the past 4 quarters

We’ve currently discussed the recent increased migration efforts that led to a successful migration away from LIBOR, but does that mean all loans refer to an alternative rate? Not quite. Currently, in the same BDC sample as of the end of 2023Q2, 75% of loans reference SOFR.

With regards to the leveraged loans and the CLO market, the results are similar, as 76% of loans reference SOFR (as of August), per LSTA.[4] The reason why these numbers are not 100% is due to contracts that were opened prior to the June 30,2023 deadline that still refer to a LIBOR reference rate.

Since most contracts are 3-months, we should expect to see a considerable amount of loans automatically migrating to SOFR (via the LIBOR act or through the triggering of an amendment). We will continue to track this migration as it nears completion.

Overall, it appears that the transition has gone quite smoothly, thanks to years of thoughtful preparation. Loans that are currently tied to LIBOR will eventually point to an alternative rate once the contracts next renew – post June 30.

The AARC, which was tasked to determine the proper alternative rates to transition to, will slowly[5] wind down its work, emphasizing that the SOFR should be deemed the best option as the alternative rate given its robust tie to the transaction-heavy treasury market.

Going forward, we will keep readers updated on the status of the remaining loans that still reference LIBOR and hope to look past the migration with a greater sense of triumph.

Sample of BDCs in our study:

[1] Alternative Reference Rates Committee

[2] https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2023/ARRC-Readout-July-31-2023-Meeting

[3] https://www.lsta.org/news-resources/libor-transition-one-two-last-hurrahs/

[4] https://www.lsta.org/news-resources/libor-cessation-t1-month/

[5] https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2023/ARRC-Readout-July-31-2023-Meeting

We’re proudly sponsoring the 9th International Funds Summit & Expo in Cyprus on October 23 and 24.

The summit brings together investment fund professionals from around the world to discuss the evolving regulatory and increasingly competitive landscape in the global asset management sector and much more.

On Day 2, Evdokia will moderate the panel discussion “The Future of Funds Administration”, where experts will explore how the future of fund administration is posing unique regulatory challenges, especially in smaller jurisdictions.

Meet our team at our Alter Domus booth and discover how our solutions can meet your needs.

Alter Domus is proudly sponsoring LSTA’s Annual Conference in New York on October 12. Connect with our team at the conference to learn how evolving risk assessments and new technologies are reshaping loan markets. Our attendees at the event include:

• Greg Myers
• Juliana Deblois
• Lora Peloquin
• Pete Himes
• Tim Houghton

Interested in discovering how our expertise and systems can bring clarity to your loan portfolio? Come and meet us at out booth!

What are some of the key considerations when identifying the right service operating model for your company?

Your operating model and managed services provider need to be able to accommodate your future growth plans. If you are considering moving into new jurisdictions, asset classes or strategies, they need to be able to flex accordingly to support that next step for your company. Crucially in today’s data-driven environment, you also want to think about your data and technology needs. Investors are demanding real-time access to information and transparency. Do you want to take on the cost and responsibility of building and maintaining the capability to provide that in-house? Many asset managers are engaged in M&A activity, which is a logical moment for a fundamental rethink of your operating model.

How is traditional outsourcing changing?

The need to access data is driving change – for the better in our view. We’re moving away from a commoditized and transactional type of model towards operationally integrated partnerships, where there’s transparency and access to data in real-time. We’re also seeing some consolidation and rationalization of partnerships. Where perhaps a manager might have had multiple fund administrator partnerships in the past, now they might have one or two deeply embedded partnerships that can cover all the jurisdictional and sector specialisms they need globally.

Co-sourcing is a relatively new concept. What is it and why might firms consider it?

Essentially, co-sourcing is an operating model where the manager maintains an in-house data and technology stack that their administrator has access to and can create and modify primary data elements. It’s a hybrid model between fully outsourced and fully insourced. The benefit it offers managers is that it allows total control and ownership of their data and real-time access to it, while tapping into the asset class and systems specialists, and talent acquisition capabilities of a fund administrator, all while reducing manager level overheads.

Beyond co-sourcing, in what circumstances might a full lift-out be the right solution for a company?

That partly depends on whether, as a manger, you have the scale and appetite to reinvest in your own technology and in-house operations or not. There are considerable advantages to partnering with a provider who constantly upgrades their technology platforms and can provide a long-term career path to valuable internal resources. There are also the economies of scale and best practices that a global administrator can offer, without being distracted by the challenges of maintaining a back office. We’ve seen great success for both clients and personnel as we’ve created a playbook to successfully assist with these types of full lift-out transitions.

With this evolution in mind, what should a company be looking for when choosing a service provider?

Ultimately a good administrator is focused on white-glove levels of service and forming a deep partnership with their clients, which will include customizable solutions and specific asset-class expertise that meets specific needs. An administrator should be viewed as a critical member of the team, who when leveraged correctly delivers significant value-add to portfolio, risk management, and investor teams. Critically, you need to have confidence that they are technologically innovative, as well as culturally a good fit for your organization.

This article was originally published in Preqin's Service Provider Report.

What do you think are the factors driving the incredible growth in distressed debt and special opportunity funds?

First, there’s the legacy effects of a long-term zero interest rate environment, and the proliferation of dividend distributions from a lot of LBOs, especially from the sponsor finance community, or private credit funds. They were done when rates were low – one floor or two for reference rates – and now it’s ticking up to the five range.

And with these legacy spreads and the current reference rates, some of these companies can’t afford that debt service as part of their operating model. That’s starting to trigger a lot of the EBITDA covenants within their underlying credit and lending agreements.

So we’ve seen a lot of our traditional private credit lenders and opportunistic managers launching special situations and credit opportunity funds, where they can step in, restructure the debt, and maybe put it on non-accrual or non-cash pay for a period of time to work these deals out. There was a bump in these funds being formed at the beginning of covid, with the assumption the pandemic would create a boom in distressed situations for the then pending economic distress.

However, due to all the government stimulus, that boom was delayed. But with the prolonged increase in rates, even with the continued economic performance, a lot of these managers are expecting that boom to commence. There are also situations like the collapse of Silicon Valley Bank that suggests there will be interesting portfolios coming to market, priced to be offloaded quickly and able to be worked out at significant returns to investors.

Do you think that same environment is fueling a rise in asset-based lending funds?

Traditional asset-based lending is typically lending where there’s a lag time between when corporate borrowers need to finance their commercial operations and bridge the period of time that their customers are paying them for the product that’s been delivered.

Up until recently, that’s been the world of a money center bank, or a super-regional money center bank that have these facilities where they will make those loans, monitor those loans and pledged collateral, and keep that relationship with a borrower. But given the ultra-sensitivity of those super-regional bank market events, those are really good loans to shed because they have high market value, without the bank to reserve against them.

So we’ve seen a number of those portfolios come to market where it’s private capital that will take on those asset based loan (ABL facilities) on behalf of the borrowers at a pretty good rate from the original bank lender.

And then there’s the role of the traditional investment bank on providing portfolio leverage, which we now see large insurers and actual funds coming in to replace them, despite all the compliance issues and strict rules around what’s applicable, what’s admissible, and substitution rights if a particular asset goes wrong. This is now becoming the realm of large insurers, since they have a more permanent capital base, one that isn’t based on deposits.

We’ve had a few clients entering into lending or refinancing arrangements, and they really liked the term loan and the borrower. The borrower then brings up the fact that they also have this ABL and would like to have the same provider for both.

So the manager decided to meet that market need, and as a result, we ended up exploring what we could do to service them, and licensed a product dedicated to the ABL space that provides transparency to the lender, the borrower and us though the operating infrastructure.

For managers looking to launch their first credit fund to take advantage of this environment, how should they think about the operational infrastructure to administer it?

When I speak with PE managers that are used to underwriting and investing in a portfolio company and valuing their portfolio once every quarter, they’re in for a very different level of activity in the credit space. The same underwriting process and the ongoing valuations occur, but additionally the bank debt pays at a minimum quarterly, and the rate resets typically quarterly. There are amortisation payments. Loans are typically originating below par. So they’ve got non-cash income that they need to recognise.

These deals get amended constantly, so there could be different compliance rules under the credit agreements. Furthermore, the maturities get extended, the size of the deal could move up and down, and all this requires a great deal of monitoring of the underlying borrower. And they need a system that will address and support all those things.

They have to decide who will be the administrative agent on the credit, whether it’s done internally, or outsourced completely.

Then there’s SEC oversight around the custody of investor assets. How are they going to build an infrastructure where they’re not co-mingling investor monies across multiple funds or different borrowers and everything else required to withstand the scrutiny of the SEC? And that’s just on the legal and operational side of things.

As a result, our clients invest a lot of resources on attorneys, compliance experts and our services because we have the appropriate systems for the agent components, the loan administration, which is tracking and ticking and tying all the cashflows, positions, rate resets, amortisation schedules, and then ultimately the fund accounting and investor reporting. Because a direct result of this growth in private credit is there is a dearth of people that know how to do credit accounting because it is very different than PE, or fund-of-funds accounting.

This ends up producing a massive amount of data to monitor and manage. The front office wants credit monitoring. The middle office needs to monitor the compliance with the credit agreements. And then the back office needs the data to produce the reports and everything else. There are big ticket systems available that cost millions to implement or off-the-shelf systems that support various functions for credit managers.

There are much lower cost solutions for data warehouses where they can build report writing software on top of the warehouse – these become a kind of integral hub for the spokes that go out to address reporting requirements. And then there are other inexpensive add-ons that can offer portfolio view technology as well.

Most clients want that data in-house, but it’s a daunting task to build internally. This is why we’re confident that outsourcing will continue to offer a compelling value proposition for the GPs looking to make the most of this particular moment in the credit markets.

This article was originally published in PDI's US Report.

We’re delighted to sponsor Debtwire’s Asia-Pacific Forum in Hong Kong on 10 October. Scott Reid, Albert Sugianto, and Jamie Loke will be attending the forum in person to examine the latest trends and developments shaping credit and distressed debt opportunities in Asia Pacific. The forum will spotlight Scott Reid who contribute to the “Asian Credit: The State of Play” panel at 9:35HKT.

Let’s talk about your credit ambitions in Asia Pacific! Schedule a meeting with a member of our team to learn how Alter Domus is helping managers seize credit opportunities in the region.

Angela Summonte is attending Pension & Investment’s World Pension Summit in The Hague from 10-12 October. She will join a range of pension fund executives and other industry experts to discuss the best practices and key strategies driving growth for pension funds around the world. Meet her at the conference to learn more about how changes across technology, financial markets, the environment, and society are transforming opportunities, and how Alter Domus is supporting the evolution of the sector.

Get in touch with Angela ahead of the summit to find out how Alter Domus’ Asset Owner Solutions can support your ambitions.

We’re delighted to be sponsoring the LMA Syndicated Loans Conference in London on 26 September 26.

Alter Domus’ Joe Knight, Juliana Ritchie, Lora Peloquin and Amit Varma look forward to meeting you at the forum to discuss the latest trends and developments shaping investment opportunities across today’s global debt capital markets.

If you’d like to find out more about how Alter Domus can support you in the syndicated loan and debt capital markets space, stop by our booth to discuss with our experts.

The US Broadly Syndicated Loan market (“BSL”) is a proven asset class with a track record of over 30 years (from the earliest leverage loan ‘prime rate’ mutual funds). CLOs are significant investors in this $1,5tn+ market. Other investors include regulated mutual funds and ETFs, and private account investors.

While BSLs offer high yields and could be attractive under an environment of increasing interest rates, they also come with several risk factors that can affect their pricing and complicate the management of a portfolio of BSLs.

Credit risk, interest rate risk, market risk, and prepayment risk are several key factors that BSL managers consider. In this article, we’ll explore the drivers of leveraged corporate loan prepayments and how BSL portfolio managers (whether it is a CLO, ETF, open end mutual fund, or private account) can potentially improve their performance and better manage investor expectations by using more sophisticated quantitative models.

Specifically, we’ll examine some of the key factors that would drive critical quantitative models to estimate prepayment risk and how these models can help BSL managers make more informed decisions to improve investment performance. 

Why prepayments matter for investors

The benefits of accurately anticipated prepayments in a BSL portfolio could be significant for investors in terms of better performance, lowers costs and more efficient portfolio management. A few examples of how a market participant could benefit from a model driven approach to better anticipate and manage prepayment risk include:

• Managing prepayment cashflows can allow BSL managers to better prepare for their next investment decisions (e.g., complying with reinvestment criteria, avoiding incurring transactions costs to meet a purchase commitment) or to better manage investor redemptions – as in the case of open-end mutual funds.
• Any time a prepayment occurs, the loan’s correspond rating bucket will make up a lower portion of the total portfolio (this is especially relevant for CLOs where ratings criteria are critical drivers for ensuring compliance with trading rules). This balance shift can have downstream consequences on whether the portfolio manager can meet the ratings portfolio criteria (i.e., WARF, Caa/CCC limit). Being able to anticipate the distribution of prepayments by rating buckets can allow a manager to better plan for these risks and enhance their ability to preserve the credit risk profile of a fund/portfolio.
• Prepayment modeling can complement the underlying investor’s expectations of returns and cash flows. For example, in static private accounts or for vehicles that are no longer in their reinvestment period, the portfolio prepayments will have a significant impact on the underlying cash flows distributed to investors.
• Proper management and projections of prepayments will assist managers to more efficiently redeploy those funds to minimize negative carry. Negative carry could have a significant impact on a BSL portfolio’s returns.
• For funds that are part of a larger fund (some CLOs and SPVs for example are consolidated into a larger fund) can incorporate prepayment management into the asset-liability management of a parent fund.
• As BSL investors increasingly demand sophisticated and quantitative approaches before investing in a particular fund, a manager that utilizes cutting-edge methods increases their opportunity of raising funds and meeting investors’ expectations – above and beyond direct links to better performance, such as market best practices, surveillance, forecasting, etc.

Factors that can influence loan prepayments

BSL prepayments are driven by a host of factors. Our analysis shows that the most pertinent fall into three categories – (i) Age of Loan, (ii) Loan Spreads and Prices, and (iii) Loan’s Recent Prepayment Activity.

Age of Loan

The first significant driver is the number of months-on-book. Recently originated loans are highly unlikely to prepay. However, as prepayments continue to increase linearly with time, there are some nuances to consider.

The linear trajectory of prepayments may have a different slope depending on the loan’s term structure, with shorter-term loans having steeper slopes. Additionally, towards the end of a loan’s term structure, there is a substantial increase in prepayment as loans get closer to their final repayment.

Loan Spreads and Prices

Loan Spreads – at the loan level

The loan’s spread is another factor worth discussing. The loan’s spread can influence prepayments in either direction. A higher spread can indicate the credit worthiness of a borrower who must allocate more cash to consider a prepayment, making doing so more challenging. However, higher spreads can also increase the borrower’s incentive to prepay, as the potential to reduce interest payments is higher.

This can especially be the case where a borrower’s credit profile has improved. Our findings suggest that higher spreads have a positive relationship with prepayment, indicating that the benefits of prepayment outweigh the costs of higher rates.

Market Loan Spread

However, loan spreads don’t affect the loan in isolation. The average spread of other loans on the market is important. The lower the average market spread, the higher the current loan’s propensity to prepay holding all else equal. This relationship suggests that when spreads are lower elsewhere, borrowers attempt to prepay either to refinance or partially take advantage of lower spreads elsewhere.

We found that when the broader market’s spread is included in a model, the current loan’s spread exhibits a stronger effect. This change suggests that the difference between the two spreads plays a key role in driving prepayments. However, this relationship becomes complicated once the next factor – Price – is introduced into the model.

Loan Price – Current

A loan’s current price is a strong predictor of prepayment probability. More specifically, a loan has a marked increase in prepayment rates if its price is between 99 and 100.5, with the peak occurring at 100. A very large proportion of all prepayments occur when the price of the loan is within that range.

Furthermore, certain factors including the loan’s spread and the market spread become irrelevant once price is controlled for – this is not surprising since the specific loan facility spread and market spreads are generally considered in the price. Thus, even though spreads likely play an important causal role in driving prepayments, the market is accounting for loan spreads and market spread when pricing loans.

Thus, when trying to predict prepayments, the loan’s price carries a good degree of information available in other loan characteristics and will generally dominate many other, though not all, explanatory variables.

Loan Price History

Another factor that matters for a loan’s prepayment activity is the loan’s price history. If a loan is priced at 100 because it was recently issued, one wouldn’t expect that loan to prepay. However, once the loan has been on the books for some time and experienced price fluctuations, then its higher price becomes more meaningful.

Recent Loan Repayment Activity

A loan’s recent behavior can affect the loan’s propensity to prepay in one of two ways. A borrower could have just made a substantial prepayment and consequently have little capacity to prepay for some time. Or they could stagger their prepayments across multiple periods. We found the latter to happen more often. Thus a loan’s most recent period’s prepayment indicates a higher likelihood to prepay again.

A few words about private debt prepayments 

In this paper we provide some insight into prepayment modeling for BSLs, and we find that a very powerful indicator of prepayments in the price of the BSL. For pure private lending, however, market prices are not readily available. In such cases more modeling around fundamental prepayment drivers – such as economic variables, broad market variable or even underlying company financial statements – would need to be explored and analyzed.

Alter Domus has performed extensive fundamental prepayment analysis for private loan portfolios. Our Alter Domus Risk Modeler provides the platform to perform and deliver such analytics. Risk Modeler is also applicable to the broader BSL marketplace for advanced analytics, including prepayment.

Conclusion

The large, established and growing BSL market presents both opportunities and challenges for underlying investors and their respective portfolio managers. Prepayment risk is a critical factor to consider, as it can impact a BSL’s portfolio performance. By employing a model-driven approach to managing prepayment risk, BSL managers can better plan their investment decisions, maintain the risk profile of a fund, manage investor cash flows (including redemptions) and better cater to investor expectations.

Key factors that influence prepayment activity for BSLs include months-on-book, loan and market spreads, current and historical loan prices, and recent prepayment behavior. By understanding these factors and their relationship with prepayment probabilities, BSL managers can make more informed decisions to optimize their portfolios. For private loan investors, modeling and managing prepayment risk may be a little more challenging given the lack of observable market prices. However, more fundamental techniques around prepayments is a field where Alter Domus has significant expertise and capabilities through our alter Domus Risk Modeler platform.

Embracing advanced quantitative models and keeping abreast of factors affecting loan pricing and prepayment risk will ensure that BSL managers can successfully navigate the complexities of the market, ultimately benefiting both the portfolios they manage and their investors. While the insights above based on aggregated market data can provide value to Alter Domus’ clients, a deep dive into an individual portfolio can significantly improve a manager’s ability to better manage prepayment risk.