US private placements stake out their future

In 2017, the US private placement market’s busiest year ever, issuance totaled somewhere between $64bn and $66bn, of which about 41% came from borrowers outside of the US, a split roughly in line with the last three years. Indeed, participants in the market often complain that “US” private placement is a misnomer, citing the international borrower base and range of currencies on offer.

Yet investors are far from satisfied. With capital flows into the market outpacing the increase in supply, competition for deals remains intense.

“Last year was a record year and that was fantastic, but the imbalance between demand chasing supply continues to plague the industry,” says Amy Judd, senior vice president and director of private placements at AllianceBernstein in New York, who notes that pension funds and Canadian investors are among the accounts taking a closer look at US private placements.

The additional capital flowing in can be difficult to trace back to its source, because some of it is managed by US life insurance companies, the quintessential private placement investors, on behalf of third parties. Occasionally, however, it is obvious, as when UK insurer Legal & General staffed up in Chicago last year and started to source private credit deals from there last March.

L&G had been running a US private placement operation from London for some time, but the additional resources in Chicago enabled it to branch out of its comfort zone — primarily the Australian market and infrastructure — and focus more on US dollar denominated transactions for corporate borrowers.

“As a relatively new US investor, we’ve been very successful in getting access to dealflow,” says Ed Wood, the former private placement banker L&G hired from Bank of America Merrill Lynch to lead the new team in Chicago. “There’s always the issue of deals that only go to existing holders, but we’ve benefited from our global portfolio of legacy investments across L&G Group and our ability to write large individual tickets.”

As investors allocate more funds to the asset class and new names enter the fray, either directly or through the big established players, the market has grown deeper, able to absorb bigger deals, and more of them.

“We have had more billion dollar plus transactions last year than I’ve seen before and the sizes of the transactions continued to get larger on average,” says Virginia O’Kelley, vice president at Voya Investment Management in Atlanta.

The record for the largest US private placement is said to be held by Mars, a household name but a secretive user of the capital markets. The confectioner raised about $2.5bn in a single offering last year.

“For high quality, well structured transactions you can certainly think about the private market as multiple-billions in one go,” says Richard Thompson, head of private placements at Mizuho in New York.

“The market could very easily have absorbed $100bn, maybe even $125bn or more,” adds Wood. “The really good credits are three, four, five times oversubscribed. I’ve seen deals 10 times oversubscribed.”

Against this backdrop, investors are looking out for the next pockets of potential issuance.

One area of growth is the real estate investment trust sector. Here, as with small, regional regulated utilities, a change to index eligibility criteria for public debt may have contributed, on the margins, to a shift from the public to the private debt market.

The index criteria update means that a single bond tranche now needs to be at least $300m in size, rather than $250m as before, to be listed in the Bloomberg Barclays US Aggregate Bond Index.

“For the regulated utility opcos or medium size Reits, that made it much more challenging for a CFO to say, ‘I’m going to take that lump in my maturity schedule, where I have $300m due in one year’,” says AllianceBernstein’s Judd.

“If the company was on the edge in terms of their ability to do that benchmark transaction, it made more sense to come to the private placement market and take advantage of the flexibility to create a smoother maturity schedule.”

This is partly because the illiquidity premium that was traditionally considered to be baked into US private placement pricing has eroded (perhaps even completely, according to some) as a result of intense lender competition whereas in the public market the premium for a sub-benchmark size deal remains substantial.

This appears to have been demonstrated in March, when two similarly-rated utility companies issued sub-benchmark size deals.

Idaho Power came first, pricing a 30-year SEC registered bond at 110bp over Treasurys for a coupon of 4.2%.

The next day, ITC Transmission, a company that owns and operates power lines in Southern Michigan, paid 15bp less for an offering five years longer. 

The company, a subsidiary of Canada’s Fortis Inc, priced a 35 year bullet private placement at 95bp over the same Treasury note, achieving a coupon of 4%.

It is worth noting, however, that ITC would have had the same rationale for tapping the private placement market before the change to the index criteria, since its deal was smaller than $250m. Some market participants downplay the impact that the raising of the threshold has had.

“That may be part of it but a bigger reason [for the record deal volume last year] is that it was communicated so clearly that interest rates were going to rise, we may have pre-funded some of the debt people were planning to issue this year,” says Voya’s O’Kelley.

Either way, preliminary figures for the first quarter of this year suggest that utilities, project finance and Reits will continue to be big areas of supply in 2018. Project finance in particular has grown as a proportion of the market as features such as delayed drawdown and committed financing for M&A and bid-style financings have become available at lower costs.

The illiquidity premium has not been the only casualty in the ultra-competitive investment environment. Some larger investors are also forgoing protections that were market standard until recently, such as swap breakage language in foreign currency transactions.

Foreign currencies such as Aussie dollars, sterling, euros and even Swedish kroner and yen are offered in two ways in the private placement market—either they are provided by investors that have foreign currency liabilities that they need to match, or they created synthetically through a swap that matches the tenor of the note.

Because the investors typically have higher credit ratings than the issuers, it is more efficient for the swap to be done by the former and the cost passed on to the borrower through the coupon.

In such deals, swap breakage language is usually included in the documentation to ensure that the investor is made whole should the borrower have to repay the debt early, for instance in the event of a covenant breach.

Recently, however, swap breakage language has disappeared from some deals as confident investors seek to offer borrowers the best possible terms. This occurred recently on a roughly A$900m transaction for a PPP highway project in Australia, the Outer Suburban Arterial Roads (OSARs) programme in the State of Victoria.

“It’s a real-time evolution of the market,” says Mizuho’s Thompson. “Not all investors are comfortable going without the swap indemnification protection.”

Those that are may reason that they don’t need the swap, perhaps because they intend to hold an asset denominated in the same currency as the swap come what may.

If an Aussie dollar private placement has to be repaid early, the investor could take a position in Australian government bonds or participate in another Aussie dollar issuance — it would not necessarily be a perfect match for the swap but it would not be a disaster either.

“Some investors are taking a commercial view that prepayment of this asset and default are very unlikely,” says Conrad Owen, managing director and head of private placements and project bonds in the capital markets group at MUFG, adding that the credit quality of the borrower is also factored into the decision to forgo this protection.

Another change to the market that observers say could unlock a new source of deals is the revision of the NAIC’s capital charge regime.

The NAIC regulates the US private placement market by imposing risk-based capital requirements on the US insurers that make up the bulk of the investor base.

Under the existing regime, there is a sheer cliff between the capital charges for NAIC 2 and 3, which relate to triple-B and double-B credits, respectively. This acts as a strong disincentive to invest in sub-investment grade credit (and a strong incentive to hold BBB- equivalent paper).

The latest proposals would subdivide the five existing NAIC ratings into 19 bands, softening the cliff between triple-B and double-B and potentially opening up the market in a new direction.

“I think there is appetite on the part of the private placement investors for below investment grade debt that has a good credit story and is well-structured, and this may allow them the ability to price it more efficiently than they have been able to in the past,” says Mizuho’s Thompson.

“The product needs to continue to expand its geographic footprint if the US private placement market is to continue growing, but that is largely going to be investor driven as they expand their credit appetite,” adds MUFG’s Owen.

But market participants will have to wait a little longer to begin assessing the impact of the reform, as the NAIC has postponed implementation until the end of 2018 at the earliest. And there are some who support the cautious approach in what is, after all, a fundamentally conservative market.

“We live in a world of glaciers,” says O’Kelley. “It will eventually come to pass, but nothing moves quickly in the regulatory environment.”

“That’s not necessarily a bad thing,” she adds. “Because you don’t want glaciers moving quickly.”