Steve Peacher: Hi everyone, and thanks again for dialing in to this episode of “Three in Five,” my name is Steve Peacher I’m President of SLC Management and today I’m really pleased to be joined by Andy Kleeman who runs our private placement team in the United States. Andy, thanks for joining today.
Andrew Kleeman: Thank you Steve.
Steve Peacher: Andy, there's a lot of talk in about alternative credit in today's market, but the traditional private place of market has been around for decades. Could you give everybody a brief explanation of this market, what kind of deals are financed in the private place of market, who are the main investors that you see in private placements today?
Andrew Kleeman: Well Steve there's a wide variety of deals in the market, the private placement market excels when issuer needs a customized financing solution. Both public and private companies issue in the market, private companies may not have ratings, or may simply prefer to keep the financials out of the public eye. An example would include the major sports leagues in North America. These transactions can be either club level financings or league financings, but are typically backed by the media contracts that the leagues have negotiated with their network partners. We also see stadium arena financings. These deals typically have contracted revenue from naming rights and advertising, as well as contracted revenue from premium box sales. There are also projections for concessions, parking, and non-team events such as concerts. Some issuers, want to know their lenders. A great example, this would be the major accounting firms which want to avoid the perception of a conflict of interest that could exist by having a borrower/lender relationship with a client that they audit. Public credits also access the market for a variety of reasons, sometimes a public credit has a story. The private market is well known for detailed underwriting and a willingness to underwrite through short term headwinds. There's a wide variety of structured deals and project financings as well, a prime example of this would be a wind or solar power where utility has a long term power purchase agreement that combined with conservative power generation forecast offers cash flows that will comfortably cover the debt. As far as participants, the private placement market has developed from the investment demands of life insurance companies in the United States. The investor base has expanded in recent years to include other types of insurance companies and pension funds as well.
Steve Peacher: You mentioned some specific examples Andy of why specific issuers might want to go to the private placement market as opposed to public markets, but you know some of these deals can be quite large, even measured in billions. So for an issue where that has a big deal to do, that is certainly big enough for the public markets, you know why would they choose to go into the private markets, as opposed to offering investors of publicly registered deal?
Andrew Kleeman: Well Steve one of the appeals of the market is again the focus on being a solution to the issuer. This could include delayed funding tranches in a deal. Perhaps issuers don't have ratings, or maybe a single rating that wouldn't match the public markets. We also see a lot of non-U.S. dollar denominated tranches as well as amortizing or not standard tenors that a company might want. For example, a European based company that wants to issue in U.S. dollars but isn't well known in the U.S. public bond market, they might get better execution in the private placement market. Sometimes the private placement market is just the flat-out best solution, an example would be a developer has an agreement with an Internet retailer to develop a distribution center backed by a 20 year lease. The lease put all the operating expenses to the tenant. As a lender we’re secured by the facility and an assignment of that lease. That debt will fully amortize based on the contracted of lease payments from the publicly rated Internet retailer. Typically, these would price 50 or more basis points wider than the public credit of the lessee. So you get the exposure to the same public credit at an exceptional yield, as well as collateral and critical infrastructure to the lessee. But the developer does not have access to those public markets leaving the private place with market as the best solution.
Steve Peacher: You know SLC Management and the team that you run has been a participant in the private place market for decades. And at the same time SLC Management's a big investor in the public corporate bond markets, and when you think of this from our client’s point of view, from an investor point of view, what are some of the pros and cons as clients think about allocating to the private placement markets versus the public bond markets?
Andrew Kleeman: We see six main benefits to private placements. The first is diversification, credits that you can't access in the public bond market that can dramatically improve your diversification. Secondly, the access to management during the underwriting and throughout the life of the deal is very valuable. The long-term performance of private placements is tied to the third and fourth advantages: covenants and collateral. Covenants get us back to the table while there’s still substantial value if a credit deteriorates. Collateral offers protection against loss in the worst-case scenarios. The fifth benefit is smaller lender groups which really streamline negotiations during any period of credit underperformance, particularly when it's a buy and hold investor base where everyone bought at par.
But, most importantly, the additional yield is a huge advantage to have an allocation of private placements. At SLC Management we've achieved spread premiums exceeding 70 basis points to comparable public investment grade bonds over each of the last five years¹. As far as the downside there's really two hurdles to investing in private placements: most investors are very concerned about illiquidity. In reality, the lack of trading is because the investor base primarily U.S. life insurance companies don't want to sell. When bonds are available in a secondary trade they typically trade at reasonable prices if it's performing credit. Operationally private placements are more burdensome, these transactions do not neatly settle in three days. It makes sense to hire an advisor who has been in the market and develop the operational capability to manage that aspect of the investment.
Steve Peacher: Thanks Andy. One final question before I let you go on a more of a personal nature, I know you've got the unique experience of, prior to getting into the investment business, having spent many years as a submarine officer in the U.S. Navy, something that most people will never experience. Is there anything about being serving on a submarine that has helped you as you transitioned over the years to the investment role that you're in now?
Andrew Kleeman: I appreciate the question Steve and I’m really proud of the service and the people I served with in the service as well. I think it certainly has, for one thing the work ethic and demands required to be a young officer in the navy is really exceptional. The level of responsibility that you get at a very young age, and frankly the leadership opportunities that you get at a very young age as well, allow you to continue to hone kind of leadership and management style. You also develop an affinity for when things just don't look right and that judgment offers a lot of value, but just the work ethic alone I think is worth a lot and it's so funny when I first got into the investment world and heard people you know in their day to day work complaints, I kept thinking about how happy I was to have a window and to breathe 21% oxygen which is just not available on submarines. And even people complain about bureaucracy it's clear they've never operated a naval nuclear reactor. Yeah there’s definitely a lot of benefits to being out as well as the time that I spent in.
Steve Peacher: Well, you and your team, I think, are known for having a high attention to detail and I assume that on a submarine it's even a higher level of attention to detail that you've got to have. So appreciate the experience. Thanks so much for your time Andy and thanks to everyone for listening to this episode of “Three in Five.”
¹ 70 basis points over relative value is the 5 year average for private fixed income USD fixed rate deals. The relative value over public benchmarks estimate is derived by comparing each loan’s spread at funding with a corresponding public corporate bond benchmark based on credit rating. Loans that are internally rated as “AA” are compared to the Bloomberg Barclays U.S. Corporate Aa Index, loans rated “A” are compared to the Bloomberg Barclays U.S. Corporate A Index, while loans rated “BBB” are compared to the Bloomberg Barclays U.S. Corporate Baa Index. For certain power and utility project loans, a best fit approach of a variety of Bloomberg Barclays’ indices was employed prior to September 30, 2016. After this date, these types of loans were compared to Bloomberg Barclays Utilities A Index and Bloomberg Barclays Utilities Baa Index, for “A” and “BBB” internally rated loans, respectively. Relative spread values obtained through the above methodologies were then aggregated and asset-weighted (by year) to obtain the overall spread value indicated in the piece.
Investment grade credit ratings of our private placements portfolio are based on a proprietary, internal credit rating methodology that was developed using both externally purchased and internally developed models. This methodology is reviewed regularly. More details can be shared upon request. Although most U.S. dollar private placement investments have an external rating, for unrated deals, there is no guarantee that the same rating(s) would be assigned to portfolio asset(s) if they were independently rated by a major credit ratings organization.
The relative value over public benchmarks estimate is derived by comparing each loan’s spread at funding with a corresponding public corporate bond benchmark based on credit rating. Loans that are internally rated as “AA” are compared to the Bloomberg Barclays U.S. Corporate Aa Index, loans rated “A” are compared to the Bloomberg Barclays U.S. Corporate A Index, while loans rated “BBB” are compared to the Bloomberg Barclays U.S. Corporate Baa Index. For certain power and utility project loans, a best fit approach of a variety of Bloomberg Barclays’ indices was employed prior to September 30, 2016. After this date, these types of loans were compared to Bloomberg Barclays Utilities A Index and Bloomberg Barclays Utilities Baa Index, for “A” and “BBB” internally rated loans, respectively. Relative spread values obtained through the above methodologies were then aggregated and asset-weighted (by year) to obtain the overall spread value indicated in the paper.
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