Funds that invest in leveraged loans have begun attracting insurance companies, pension funds, foundations, endowments and family offices. Because leveraged loans are extended to companies that already have a lot of debt, and are considered riskier, they cost more than other types of borrowing and deliver higher returns to those who invest in them.
Part of the appeal is that in today's competitive lending environment, which is flooded with debt capital and low on places to put it, many lenders have had to come down on interest rates and become more flexible with loan terms in order to score a deal, and in turn, investors have not always seen strong returns.
Returns from leveraged loan funds can hover around 10 to 12 percent, compared to unleveraged funds, which can return around 4 percent to 7 percent, says John Finnerty, senior managing director, NXT Capital LLC. NXT won Mergers & Acquisitions' Lender of the Year award for 2011.
In July, the Chicago-based lender closed its first leveraged loan fund - NXT Capital Senior Loan Fund II LP, a $783 million fund that invests in senior debt transactions originated and underwritten by NXT Capital's corporate finance group. These include senior-secured, stretch senior, unitranche, second-lien, term over revolver and last-out term loans made primarily to private equity-sponsored middle market companies in a wide range of industries.
In January, Chicago-based lender Monroe Capital LLC closed a $500 million leveraged loan fund, called Monroe Capital Senior Secured Direct Loan Fund LP, which will also invest in senior debt transactions to private equity-backed and other middle-market companies. Leveraged loan funds are a standard part of Monroe's business, says Monroe CEO Ted Koenig. The firm previously closed a $250 million leveraged loan fund in 2011, and will likely raise another in 2014, Koenig says.
The leveraged loan funds provide very low risk from an investment standpoint because they are in senior debt and "generate very consistent and boring returns," Koenig says. "Institutional investors, with the low interest rate environment, don't have any place where they can put their money to generate reasonable returns, so what has happened is that they found the private debt space, which is much more attractive," he says.
Yields have come down in the last 18 to 24 months because of the amount of money flowing into the debt markets, but leveraged loan funds still provide a more attractive return in a relatively low-risk environment when compared to fixed-income sources of return.
"Until interest rates rise, you will continue to see money flow into the leveraged loan space. Unfortunately, I think that actually puts pressure on yields," Finnerty says.