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March 22, 2012

Understanding Senior Secured Loans

In uncertain economic environments, investing in senior secured debt can be defensive in nature. It is the most senior part of a company’s capital structure, and therefore typically has the first claim on the assets and cash flows of a company. This means senior secured loans receive payment in full before other security-holders in a firm, including public bondholders. In addition, senior secured loans pay interest at rates that change periodically on the basis of a floating base lending rate, generally the three-month USD London Interbank Offered Rate (“LIBOR”), or U.S. Prime Rate, plus a fixed premium (or “Spread”). Given this floating rate structure, pricing in the secondary market of senior secured loans is less sensitive to changes in interest rates than it is for other fixed income securities with similar maturities. In addition, the floating interest rate structure of senior secured loans, serves as a hedge against rising interest rates and inflation.

The combination of seniority in capital structure and variable rates has historically resulted in an asset class which has been characterized by lower price volatility relative to other income securities, and has provided competitive returns.

What are Senior Secured Loans?

  • Generally secured by all of the company’s assets and senior to all other debt
  • Have a floating interest rate structure; a hedge against rising interest rates and inflation
  • Term of the loan is typically 6 to 8 years
  • Used in Acquisitions, Leveraged Buyouts, Capital Expenditures and General Corporate Purposes

Structure Offers Superior Downside Protection:

  • Senior-most obligation in the capital structure
  • Interest paid before bond and equity holders
  • Secured by borrowing company’s assets
  • Restrictive covenants preserve collateral to protect against credit deterioration (cash flow, interest coverage and leverage tests)
  • Interest payments frequently stay current through bankruptcy
  • Ability to control loan restructuring/workout process

General Motors Drives Home the Advantage of Secured Loans

When giant U.S. automaker General Motors went into bankruptcy, many stakeholders were left in the dust. Shares of GM, which peaked above $90 in 2000, became worthless. They were completely wiped out. Holders of GM unsecured bonds – mutual funds, pension funds, hedge funds and retail investors – did not fare much better. When the federal government stepped in to bail out GM, the company’s $27 billion in unsecured bonds were exchanged for 10% of the stock of the restructured GM and warrants to purchase additional equity. These bondholders, who certainly expected that a bond in an industry powerhouse would pay their entire investment back, virtually saw a complete loss of principle.

Remarkably there was one bright spot in GM’s capital structure: secured loans. GM and Saturn secured these obligations with a first priority security interest in its equipment, fixtures, documents, general intangibles, all books and records, and their proceeds. So what happened to these loans?

During recent bankruptcy court proceedings, it was determined that all amounts outstanding under GM’s secured debt, close to $6 billion, were to be repaid in full. In other words, while equity and bondholders forfeited billions, investors in the term loan were made whole, even in the direst financial circumstances.

Note: The collateral securing senior secured loans may decrease in value, lose its entire value over time or fluctuate based on the performance of the company, which may lead to a loss of principal. An investment into a BDC or a senior secured loan is subject to significant risks and may be considered speculative. Investing in private equity and private debt is subject to significant risks and may not be suitable for all investors. This is neither an offer to sell nor a solicitation of an offer to buy the securities described herein. An offering can only be made by a prospectus.

 

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