Private (direct) lending has more than doubled to over $750 billion notional outstanding in the last decade.¹ By assembling teams of credit specialists and deep, consistent sources of capital, they have become a primary source of financing for small- and medium-size enterprises (SMEs) that are not serviced by the banking sector. The loans themselves are a mix of bilateral and broadly syndicated. This case study is from the point-of-view of one such direct lender ‒ the firm.

Background:

As an unregulated entity, the firm’s LIBOR transition is driven primarily by economics rather than guidance from, for example, the Alternative Reference Rates Committee (ARRC) or the Comptroller of the Currency (OCC). Therefore, on the asset side of the balance sheet, the firm is focused (with respect to the USD LIBOR transition) on:

• Continued origination of loans that fit its credit and yield parameters
• Offering loan products that are aligned with borrowers’ operational and pricing requirements
• Managing asset impairment that may arise from/during the transition from USD LIBOR
• Liquidity and price transparency/comparability of those loans for which there is an active secondary market
• Remediation as appropriate of legacy transactions that mature beyond June 30, 2023

On the liability side, the main LIBOR transition focus is on the firm’s program for collateralized loan obligations (CLOs) ‒ a form of securitization that enables more efficient funding through credit tranching while allowing active management of loan assets.

• CME Term SOFR was endorsed by the ARRC on July 29, 2021 for use in all cash market financial products as well as certain OTC derivative products.
• Although USD LIBOR will be published through June 2023, in the meantime, existing LIBOR transactions/positions will be subject to evolving relative liquidity of LIBOR and SOFR instruments, with resultant effect on asset pricing and valuation.
• The firm is active in two distinct types of CLOs – commercial real estate and syndicated loans. It is possible that evolving rate conventions may be different between the two. Within each type of CLO, there may be basis risk (mismatch of assets and liabilities) driven by investor rate preferences.
• In general, direct lenders’ valuation and risk expertise lies in credit analysis, not interest rate dynamics. Thus, loans are mostly floating-rate and borrowers tend to be middle market and low-middle market corporate clients. Often, they are small-to-medium enterprises (SMEs) with basic operational capability.
• In the firm’s case, they specialize in:
  • commercial real estate
  • multi-lender facilities (syndicated loans)
  • trade finance

• To maintain the ability to offer credit products that flexibly fit borrowers of diverse sizes and sophistication across asset classes, the firm must adapt from a one-size-fits-all USD LIBOR environment to a potential mix of accrual, rate set, and payment conventions.
• Asset liquidity risk now will be largely dependent on the evolving relative depth of the LIBOR and SOFR markets, in addition to asset-specific liquidity concerns. This is important for pricing at origination and for secondary market considerations.
• Remediation of legacy transactions affects both loan assets and CLO liabilities; assets with sub-par fallback provisions should be recognized and managed.
• Investors in CLOs may have rate preferences that differ from rate conventions of the pool’s underlying assets.

• Prepare to execute SOFR-linked loan and CLO products.
• Maintain a continuous dialogue with clients to explain how the transition will affect them and to understand and evaluate demand for new SOFR-linked loan products.
• Monitor market activity in USD LIBOR and SOFR and adjust portfolio actions for liquidity changes.
  
• Analyze the effect of potential basis between CLO assets and liabilities to evaluate risks and opportunities.

1. Bank of America Research

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