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Illiquid Assets Are Getting More Investable - Muzinich & Co

Eric Green, 9 April 2019

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Welcome to the field of a "business development company" and insights into the world of private debt.

Even before the financial market tsunami a decade ago (yes, it's that long ago) the role of alternative assets such as private equity in portfolios was getting attention. The "Yale Model" (taking its name from the endowment fund of the US university) was influencing thinking in areas such as retirement savings programmes back in the early Noughties, as the editor of this news service recollects. A common error, so the Yale endowment fund and its followers said, is that investors over-pay for liquidity. For those willing to accept low liquidity, returns over the medium term can handily beat those of more liquid investments. That's the trade-off - there are no free lunches in capitalism.

In more recent times the benefits of illiquid investments have gained more of a following. A period of ultra-low or even negative interest rates has encouraged the shift to some extent.

A nagging worry today is that private equity and certain other corners of the "alternative" space are getting hot. There is more than $1.0 trillion of unused capital - known in this area as "dry powder" - can it be all absorbed without discomfort? And even if the benefits of such assets are clear, how large a part should they play in clients' portfolios? And what of the area known as private debt?

Eric Green, who is co-head, private markets, Muzinich & Co, an investment firm, addresses such questions. This news service is pleased to share these views and invites subscribers to respond. Email tom.burroughes@wealthbriefing.com


Private debt has become an increasingly popular asset class in recent years, as investors have turned their attention to more illiquid strategies to obtain a decent yield. For institutional investors, with large cash balances and long-term investment horizons, it has proven particularly popular.

Yet for wealth management/high net worth clients, accessing this asset class has proven difficult due to the large investment required and associated illiquidity.

In Europe, non-bank lending remains a relatively recent phenomenon, primarily as a direct result of the global financial crisis. In the US, however, banks have been largely disintermediated from the lending market for decades, as increased regulatory constraints have limited their ability to lend to small and medium-sized companies.

This contraction in bank lending provided an opportunity for alternative providers of debt to the US middle market (companies with revenues from $10 million to $1 billion) through a structure known as a Business Development Company.

A unique structure
A BDC is a unique structure that is designed to invest in small and mid-sized US businesses; its underlying investments are illiquid but the BDC can be listed on a public exchange, which provides the liquidity. Within the US middle market, where BDCs operate, there are an estimated 85,000 businesses with revenues above US$25 million. This market is continuing to enjoy strong growth, estimated at 7.9 per cent over the 12 months to December 2018. This compares with just 4.7 per cent for companies listed on the S&P 500 (as of 31 December 2018).

Asset managers often have clients, particularly within the wholesale market, who expect to be able to liquidate their investment at short notice. To facilitate an active secondary market, a minimum issue size of $400 million for high yield is typically required and, in our view, most investors require over $1 billion of outstanding bonds. As a result, there is no active liquid secondary market for the debt of US middle-market companies, given the smaller size of their balance sheets.

However, as noted above, the public ownership structure of a BDC (it can list on the New York Stock Exchange or the NASDAQ) typically allows investors liquidity, while still benefiting from the illiquidity premiums associated with private debt.

It is worth highlighting that, just like traditional equities, as a publicly-listed entity the prices of BDCs tend to fluctuate within a range as they can be affected by macroeconomic changes, the evolving credit cycle as well as broader investor sentiment. That said, investors typically receive dividends which can be around 8-10 per cent per year, which assist in helping compensate for the increased levels of volatility.  

Furthermore, as a form of fixed income, there is always the risk of a company defaulting on its debt obligation. However, we note that loans to US middle-market companies have shown both lower default rates and higher recoveries when compared with broadly syndicated loans. Middle market loans also tend to present a lower correlation to other major asset classes, providing another important avenue of diversification for a portfolio.

The tax advantage
An investment into BDCs can also prove beneficial for wealth managers and high net worth individuals from a tax perspective. Like Real Estate Investment Trusts, as long as the BDC meets certain income, diversity and distribution requirements, the company may pay little or no US corporate income tax.

BDCs typically elect to be taxed as regulated investment companies (RICs) under the US Internal Revenue Code. This requires BDCs to distribute at least 90 per cent of taxable income annually as dividends to investors. Typically, BDCs pay dividends on a quarterly basis.

The PATH (Protecting Americans from Tax Hikes) legislation in the US has transitioned tax treatment to investors’ country of domicile tax treaty, thus providing a simpler structure for offshore investors to access the US private debt asset class without incurring effectively connected income i.e. they are not required to pay US income tax.

The BDC structure also reduces the risk of ‘trade or business’ tax concerns related to loan origination activities, as BDCs are US-domiciled entities, which can be a further benefit to non-US based investors.

As the US private lending market continues to mature, we believe that BDCs could represent an attractive investment opportunity for investors who are interested in allocating to private debt, but find the upfront investment and illiquidity too high a barrier to entry.

About the author
Eric Green joined Muzinich in 2012 from Cyrus Capital Partners, a credit opportunities firm, where he was a managing director. Previously, he was the senior partner and portfolio manager of FriedbergMilstein (a direct debt origination firm), a partner and managing director of JP Morgan Partners and a managing director of BNP’s Merchant Banking group. He started his career at GE Company/GE Capital.

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