Senior secured loans are private corporate debt instruments, commonly issued by below-investment-grade companies and secured substantially by tangible and intangible assets of the borrower. Loans are typically used to finance acquisitions, leveraged buyouts (LBOs) or as a means to recapitalise an existing corporate entity, underwritten by a lead bank and syndicated to other banks and institutional investors. They are technically not securities, nor traded on any exchange, but rather traded “over the counter.”

Senior secured loans hold a senior, secured position in a borrower’s capital structure where the debt ranks first in order of payment as matter of contract and has a first ranking claim on security proceeds. They pay a floating rate of interest made up of a base rate plus an additional fixed coupon called the “spread” to compensate for credit risk. Interest payments are usually paid quarterly, and in some cases more frequently.

Extensive covenant packages in the loan documentation, which set minimum standards for a borrower’s financial conduct and performance, protect enterprise value cover for lenders. If breached, lenders can enforce corrective action.

Investments are generally led by professional private equity investors.

Mezzanine loans are junior secured, private corporate debt instruments, commonly issued by below-investment-grade companies. Mezzanine loans benefit from the same collateral as senior secured loans but on a second ranking and subordinated basis. Mezzanine loans are typically used to finance acquisitions, leveraged buyouts (LBOs) or as a means to recapitalise an existing corporate entity. Investments are generally led by professional private equity investors.

Mezzanine tranches can be provided via a wholly contractually-priced formula, involving a combination of cash and accrued payment-in-kind (PIK) interest, or on a warranted basis, where part of the remuneration is driven by a share in the equity value of the business upon exit. The latter is often referred to as an “equity kicker.”

Some mezzanine providers also have the latitude to lend on a wholly-PIK basis which, in conjunction with the “bullet” (1) repayment characteristic of mezzanine, provides financial sponsors with additional options in generating optimal financing structures.

Extensive covenant packages in the loan documentation, which set minimum standards for a borrower’s financial conduct and performance, protect enterprise value cover for lenders. If breached, lenders can enforce corrective action.

_{(1) A way to structure the repayment of a loan in which the borrower does not pay the principal over the life of the loan, but rather makes a lump sum payment at maturity.}

As a way to tap into bond market liquidity, while also attracting traditional senior secured loan investors, issuers are increasingly approaching the market with senior secured bonds. The terms of these issues are by no means uniform, particularly in terms of the quality of security being offered, but for some of the new senior secured bonds, the terms combine several of the most attractive features of the senior secured loan and the unsecured high yield bond markets.

As at October 2010

Private equity firms generally issue a combination of loans and high-yield bonds in the financing of LBOs. Loans are typically arranged by investment banks and financed by a syndicate of commercial banks and loan fund managers. They tend to be senior secured, floating-rate instruments. High-yield bonds are also underwritten by investment banks but normally financed by a combination of retail and institutional credit investors. They are often fixed-rate instruments and unsecured, although in some cases issuers will sell senior secured bonds.

Senior secured loans rank above unsecured bonds in the capital structure. As a result of their ranking and the security over company assets, recovery rates on loans have historically exceeded those on high-yield bonds.

Loan investors have access to substantial private information about the borrower. Such private information includes management projections and third party due diligence reports prior to primary market investment, and monthly and quarterly management information on an ongoing basis. High-yield bond investors are generally restricted to accessing public information.

Loans also usually come with covenant packages, allowing for early warning of underperformance, pre-emption of defaults and protection of enterprise value. Covenants for high-yield bonds are generally limited. Yet, while secondary market liquidity has greatly improved for European loans, high-yield bonds are more frequently traded and can normally be sold more easily, should an investor seek to exit a position.

Babson Capital Europe currently manages two co-mingled senior secured loan funds, one of which focuses on the European market (Babson Capital European Loan Fund), while the other one aims to capture relative value opportunities across the US and European loan markets (Babson Capital Global Loan Fund, co-managed alongside Babson Capital Management LLC). 

Babson Capital Europe manages a further fund in cooperation with Babson Capital Management LLC, the UCITS compliant Babson Capital Global Senior Secured Bond Fund, which provides investors with exposure to the US and European senior secured bond markets. 

Babson Capital Europe manages two further UCITS compliant high yield bond funds, one of which focuses on the European market (Babson Capital European High Yield Bond Fund), while the other one aims to capture relative value opportunities across the US and European bond markets (Babson Capital Global High Yield Bond Fund, co-managed alongside Babson Capital Management LLC).

The investment opportunity in global loans and bonds is also accessible via the Babson Capital Global High Yield Strategies Fund.

In addition, Babson Capital Europe manages several separate account mandates of senior secured loans and bonds on behalf of large institutional investors as well as three dedicated mezzanine loan funds (Almack Mezzanine I, Almack Mezzanine II, Almack Mezzanine III) and a global distressed debt fund (Babson Capital Global Distressed Credit Fund).

Babson Capital Europe also manages eight cash flow arbitrage collateralised loan obligations (Duchess I, Duchess III, Duchess IV, Duchess V, Duchess VI, Duchess VII, Malin and Fugu CLO), all of which invest in debt sourced in the European leveraged buyout market.

All potential investments are reviewed by Babson Capital Europe's dedicated investment team and presented to a formal credit committee. The investment team draws on a deep pool of expertise. Investments are steered by a credit committee comprising seasoned market professionals with investment and trading experience over several credit cycles. Babson Capital Europe’s credit committee panel members are Ian Hazelton, CEO and Chairman of the credit committees, and the Managing Directors David Wilmot, Zak Summerscale, Adam Eifion-Jones, Martin Horne and Stuart Mathieson. The approval process is a three-stage process which is designed to eliminate unattractive proposals early and to focus the analytical effort on the most promising investment opportunities.

Each fund has a set of documented investment guidelines, within which Babson Capital Europe operates. In the case of separate account mandates, such guidelines are tailored to the requirements of the investor.

Third party fund administrators are typically responsible for monitoring the eligibility of trades within the limits set by the fund documentation.

Access to assets and replicating fund diversity are the main constraining factors for direct loan investments. The European loan market is predominantly a private market, which means you have to be an active and recognised player to be able to invest. For primary loan investments you have to be invited by the arranging bank or private equity sponsor to participate in the deal. For secondary loan investments you have to have an extensive network with bank trading desks. Furthermore, the minimum transfer amounts for loans, which are set by the arranging banks, are usually in excess of €1 million which may hinder investors who wish to invest directly in loan assets.

A single investment in a fund provides an investor with a diversified portfolio, by borrower, industry and geography. If investors were to invest directly into the asset class they would not benefit from this diversification.