Direct lending, the largest part of the private credit asset class, is a hot topic these days. A number of advisors are asking for further education on some of the key portfolio metrics for direct lending fund vehicles, particularly when it comes to measures of leverage. Here are four of the most common metrics and our perspective on how best to evaluate them:
Loan-to-Value
One of the most important metrics for credit managers is loan-to-value (LTV). This refers to the amount of debt a private equity (PE) fund sponsor has borrowed relative to the total value of its subject portfolio company.
Similar to the way a home-purchaser who puts down a larger down payment is less likely to default on their loan, a company owner who puts in more equity is generally considered a less risky borrower. A lower loan-to-value generally indicates less leverage on a company and therefore a less risky loan.
If you put a 20% down payment on your home and borrow the remaining 80% from the bank, your mortgage would have an 80% loan-to-value. For the above hypothetical example, “Company A” has borrowed 33% of its total value (in the PE world this is called “enterprise value,” and it functions roughly similarly to the “market capitalization” plus the debt, net of cash of a publicly traded company).
Company or Deal Leverage
In the private equity world, “deal leverage” is a key metric for identifying the amount of leverage a company is using. Deal leverage refers to the size of the loan compared to the earnings of the company, and it’s given as a multiple.
To continue the example of Company A, let’s say the company makes $300M in revenues, of which $200M goes to costs, leaving $100M in operating earnings before tax (in the PE world this measure is called “EBITDA” or “earnings before interest, taxes, depreciation, and amortization”). That means this company has deal leverage of 5x EBITDA ($500M loan/$100M earnings).
Interest Coverage
Lenders often use an “interest coverage ratio” to measure the ability of a company to make the interest payments on its loans. Interest coverage is simply the company’s earnings, as measured by EBITDA, divided by the interest payments on outstanding debt. In our example, the $500 million loan by Company A has a 10% annual interest rate which results in $50 million of annual interest payments. The company generates $100 million of earnings which is twice the amount of the interest payments, or said another way, an “interest coverage ratio of 2x”.
Fund-Level Leverage
The final key metric for analyzing leverage for a direct lending fund or vehicle is looking at the leverage utilized directly by the fund structure itself. The leverage ratio of the fund is completely separate from the leverage levels of the underlying companies.
In this hypothetical example, a fund with $1.5B in AUM (“Fund Z”) is comprised of $850M of client investments plus the use of a $650M credit facility to make additional private direct loans. Dividing the $650M credit facility (fund debt) into the $850M of investor capital results in a .77x fund leverage ratio for the fund or vehicle.
Conclusion
In our example, Fund Z has fund-level leverage of 0.77x. The loan to Company A within Fund Z has an LTV of 33%, a company or deal leverage of 5x, and an interest coverage ratio of 2x. Of course, these measures can be aggregated across the portfolio to give an average LTV, deal leverage, and interest coverage ratio for Fund Z. These average fund measures can then be compared to competitor funds.
While each leverage measure is a different number, they all relate to each other — except for the fund level leverage — and each gives a slightly different picture of the relative risk of the underlying portfolio of loans.
The savvy investor will compare these measures when evaluating direct lending funds to understand the type of risk they may be taking in return for the stated fund yield that they expect to earn.
