Private lending as an investable asset class has been historically classified as niche and been reserved for large institutional investors within closed-end investment vehicles. In Canada, we were one of the first managers to launch a pure direct lending fund for institutional investors. However, investor demand and bank regulation has promoted an inexorable trend in lending over the past thirty years towards an efficient market where loans are syndicated and traded much like bonds and shares in relatively transparent and liquid markets. Today, the U.S. has a mature secondary loan market where institutional investors can avail credit ratings, independent research, and quotations to help mark their portfolios. In fact, loans are considered a distinct asset class in the U.S. In contrast, the Canadian secondary loan market is still very small and undeveloped. We believe the main reasons for this disparity include: the large size of the Canadian chartered banks relative to the domestic loan market and their control of primary supply; the diversity of banks’ loan portfolios given their extensive branch networks and coast-to-coast lending capacities; and an absence of institutional investor demand due to lack of familiarity or expertise.
Canadian banks have been very efficient in building loan portfolios in the large segment of the commercial market and investment grade corporate market. Smaller commercial loans, where credit spreads are benchmarked off the Prime Rate (rather than interbank offer rates or yields on bankers’ acceptances, which apply to larger loans) are typically processed with minimal staff involvement based on internal rating systems that look for positive earnings history, strong tangible net worth, and sufficient collateral. Industry preferences also have an influence on the loans that Canadian banks will approve. For example, we have recently seen a rise in deal referrals from banks that are rejecting loan applications in the upstream segment of the oil and gas industry. A more defensive posture by banks has resulted in sectors like media, construction services, and technology becoming out of favour.
According to Standard and Poor’s, since the early 1990s, large banks have adopted portfolio risk management techniques that measure the returns of loans relative to risk, and have learned that bank loans are rarely compelling investments on a stand-alone basis. Monitoring costs are very high so banks diversify by number of loans to try and lower portfolio risks (see our Q3-2010 letter wherein we challenge this conventional belief). It is not uncommon to have Canadian commercial bank officers manage 200 or more credit relationships at the same time, which requires banks to have a tolerance for some losses but maintain rigidity in the criteria for loan approvals. Non-credit related income sources are driving the relationship banks want with borrowers.
Banks are reluctant to extend credit to borrowers unless the total relationship generates attractive returns, preferably from activities that do not require a capital charge. In Canada, such non-credit related business includes cash-management services, foreign exchange transactions, brokerage services, pension-fund management, employee transaction processing, and capital markets advisory work. The spread on credit has become less important for banks than the amount of fee-driven business that can be captured as a result of a borrowing relationship.
Pricing loans based on relationship returns favours larger and more established borrowers. It was no surprise then that, prior to the financial crisis, U.S. non-bank finance companies held the largest market share of middle-market commercial loans in Canada. The size and concentration of the Canadian banking oligopoly has been the source of structural inefficiencies in middle market lending that have contributed to persistent returns for non-bank lenders and dedicated funds like ours.