Q&A: Oaktree Capital's Raj Makam

Q: Why does the direct lending space appear to be overheating?

A: Investors have flocked to it with the view that they can get a premium over liquid markets and bonds and with the view that they are senior in the capital structure and therefore on a risk-adjusted basis it’s fantastic. And then investors in general have got more comfortable investing in illiquid credit. As a result, there has been a massive influx of capital, and whenever that happens, returns go down and risk goes up. The spread between broadly syndicated loans – the liquid part of the market – and direct lending is around or below 1%, it’s the lowest I’ve ever seen.

Q: In what ways are investors taking on more risk?

A: There are three elements. First, you are putting more leverage on a company and taking riskier terms. The second part is not so intuitive. Generally speaking, senior debt-to-EBITDA is 4x, it’s been that way for several years. Investors are attracted by the promise of a 10% net return, but you cannot get that if you stick to senior debt-to-EBITDA at 4x and pricing at LIBOR plus 425 basis points. So, what do people do? Go deeper into the capital structure and still call it senior. Approximately two-thirds of the market is now above 4x leverage. You could argue that the paradigm has changed – it’s a new model – or you can say senior lenders or managers are taking junior risk and calling it senior. This is a problem because managing junior risk is very different from managing senior risk.

Q: What is the third element?

A: The other element is how leverage is marketed to investors. People say they are using one-to-one leverage, which is modest when you consider that a CLO [collateralized loan obligation] might be 10-to-one and a home mortgage might be two-to-one. However, with structured vehicles like CLOs, the term of the leverage is consistent with the tenor of the assets. With a senior loan, there can be a massive mismatch – you’ve got leverage of three to four years, but the term of the loan is much longer. The counterargument is that you can always refinance, but that’s easier said than done. Middle market leverage is provided by a limited set of people and most leverage facilities have strong terms on what you can use leverage for, which effectively means they can more quickly control lending any time.

Q: Are covenants becoming looser as well?

A: My job as a manager is to pick good credits, but the more important job is to have things I can control. While I can’t anticipate everything that could go wrong, if something does go wrong, I want to be able to do something about it. Maintenance covenants are largely gone from the broadly syndicated market – approximately 80-90% of deals don’t have one. This is coming down to the middle market in that people are still using covenants, but they are weaker, they leave a lot of room. You need to be careful. Everyone says they aren’t doing it and that everyone else is. Direct lending is overheated, and I worry about it.

Q: What does it look like when things go wrong?

A: You start at 4.75-5x debt-to-leverage and then you’re at 7x and the leverage guy is breathing down your neck, asking to be paid off. And unlike the broadly syndicated market, there is not much distress to speak of in the middle market, so you can’t sell to a distressed player. That’s where we think junior debt comes to the fore – you can use it to refinance some of the senior debt, but it requires a different kind of conviction to provide junior capital to refinance senior debt in a tough environment.

Q: How is managing junior risk different to managing senior risk? 

A: The orientation is different. A senior lender is high up in the capital structure, and he just wants his coupon; he knows the private equity guys and the junior debt guys will be the ones that lose out. With junior debt, you must think about the liquidity needs of the company and how they can be met. You need to keep the senior lenders happy; you need to make sure management is happy. Taking a longer-term perspective, you might be putting in more money to support liquidity or not taking interest payments, which amounts to the same thing. You are getting your hands dirty. You don’t own the company – you don’t want to – but you don’t want to lose value either. Depending on who it is, the equity guy will either tighten his belt and wait for the market to come back or they go for it and take on more risk. As a junior lender, you can’t panic.

Q: How are best-in-class managers navigating these conditions?

A: The middle market is extremely resource intensive, especially when things go bad. In other markets, you can say my base case is that, of these 10 factors, four will happen, four might happen, and two won’t happen. We are now in a market where you must assume that each one will happen. The best strategy is to focus on what you can do when they happen – and this requires bandwidth. You need a lot of people, a conviction to work on tough credits, and experience. This is not a market to be raising lots of money because you can’t invest in the right way. You need to pick your shots, be deliberate, and recognize there is a bias for downside over upside right now, so be ready for it. And it’s not just being ready holistically, but also having the right tools and structures. You can’t just rely on a good relationship with the sponsor.

Q: Will the lender base consolidate once the market turns?

A: Our office is on the 34th floor of a building in midtown Manhattan, which is as dense as it gets. I used to say, ‘If you open the window and throw a stone, you’ll hit a direct lending manager, because there are so many in the market.’ Once the market crashes, deals will dry up, because no one is selling unless they have no choice. Value-oriented investors will dominate, buying into troubled companies and sectors that are out of favor, but overall activity will decline. Some of those who stop lending will also need help, whether that is selling their portfolios or selling themselves. This is already and will be more evident in the BDCs [business development companies]. They will be trading below NAV [net asset value]; they can’t raise money, but they need to produce a dividend; and if they don’t produce a dividend, the stock takes a hit. They must sell assets. Meanwhile, all the relative value guys who are doing middle market junior lending right now, will vanish because they will go after public market opportunities. That’s what happened in the fourth quarter of last year, when the second lien market, which had been robust, went to zero overnight.

Q: Regarding mezzanine lending, is unitranche another function of the bull market?

A: Unitranche is still only 15-20% of the market and there are pros and cons to it. First, the pros. As a lender, it’s a market of limited size, so you can invest quickly and control the entire capital tranche, which means you control your own destiny. As a borrower, you only need to deal with one person, which makes things easier. Now the cons. As a borrower, if you do well you cannot pay off the most expensive part of the debt because there’s only one tranche. Also, your destiny is controlled by one person, and ideally, you want a set of lenders to know about you, so you have diversity in the lender base as you grow your business. As a lender or investor, most of the unitranche providers came in after the last cycle, so it hasn’t been risk-tested yet; and the junior risk hasn’t gone away, it is still embedded in the structure. There is also synthetic unitranche – where the debt is cut into senior and junior tranches on the back end and multiple lenders or parties own the paper – which hasn’t been tested that often in bankruptcy court. Furthermore, because you are investing at scale – $150-200 million per deal – unless you have a massive fund of $5-10 billion, you don’t have diversity in exposure.  

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• Oaktree Capital