The FAST Take

Image
Decorative background

Four Key Credit Metrics for Evaluating Direct Lending Portfolios

01/03/2024

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.

Stacked bar graph showing breakdown of $1.5 billion company value into $500m Loan and $1bn Equity

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).

Stacked bar graph showing breakdown of $500m Loan into Company Revenue
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”.

Stacked bar graph showing company revenue breakdown into costs and $100m earnings and $50m annual interest
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.

Stacked bar graph showing breakdown of fund into $650m Credit Facility and $850m Equity

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.

Icon of bulb with stopwatch inside

Never Miss a Take

Never Miss a Take

The Financial Advisor Solutions Team

Ares Wealth Management Solutions

Carlin Calcaterra

Managing Director, Financial Advisor Solutions Team

Brendan McCurdy

Managing Director, Financial Advisor Solutions Team

Ready to learn more?

AccessAres is your resource for education and information about the private markets. Talk to us to learn more about these important asset classes.

Professional woman smiling at her desk
×

Contact Us

Connect with our Wealth Management Solutions team that works with Financial Advisors and Private Wealth Managers to provide alternative solutions. For investors based in EMEA and APAC, please visit our Non-U.S. Investors Contact section.

 

Individual Investors

Reach out to your Financial Advisor.

 

Financial Advisor Inquiries

       (866) 324-7348

 

Financial Advisors Information Request

You are now entering the AccessAres website

AccessAres is the thought-leadership and educational division of Ares Wealth Management Solutions. The materials distributed by AccessAres are for informational purposes only and do not constitute investment advice or a recommendation to buy, sell or hold any security, investment strategy or market sector. Ares Wealth Management Solutions is a global brand of Ares Management Corporation.

You are now leaving the AccessAres website

AccessAres is the thought-leadership and educational division of Ares Wealth Management Solutions. The materials distributed by AccessAres are for informational purposes only and do not constitute investment advice or a recommendation to buy, sell or hold any security, investment strategy or market sector. Ares Wealth Management Solutions is a global brand of Ares Management Corporation.

You are now leaving the AccessAres website

AccessAres is the thought-leadership and educational division of Ares Wealth Management Solutions. The materials distributed by AccessAres are for informational purposes only and do not constitute investment advice or a recommendation to buy, sell or hold any security, investment strategy or market sector. Ares Wealth Management Solutions is a global brand of Ares Management Corporation.