Jongha Lim, Bernadette A. Minton, and Michael S. Weisbach
Syndicated Loan Spreads and the Composition of the Syndicate
Journal of Financial Economics | Volume 111, Issue 1 (Jan 2014), 45-69

During the past decade, non-bank institutional investors are increasingly taking large roles in the corporate lending, especially in the syndicated loan market. A puzzling aspect of this phenomenon is that non-bank institutional investors, especially hedge funds and private equity funds, have substantially higher required rates of return than banks, yet participate in the same loans and consequently receive the same returns on these investments.

Why do some facilities have participation of non-bank investors while others do not? Why do various types of institutional investors, whose required ex ante returns are substantially different, invest in the same loan facilities as one another? How does their presence affect the loan spread? In this paper, we address these issues using a sample of 20,031 facilities (or tranches) of leveraged loans that were originated between 1997 and 2007.

1: Relative Portion of “Non-bank” versus “Bank-only” facilities
There is substantial participation by non-bank institutions.

We first document that there is substantial participation by non-bank institutions in these loans. Of the 20,031 leveraged loan facilities, 13,752 are associated with a syndicate containing only commercial or investment banks (bank-only facilities), while the remaining 6,279 have syndicates containing at least one non-bank institutional investor (non-bank facilities) (see Figure 1). These institutional investors are most often finance companies (4,603 loan facilities), private equity or hedge funds (2,754 loan facilities), and mutual funds (1,010 loan facilities).

Non-bank facilities have higher spreads than bank-only facilities, controlling for other factors that affect the loan facility's spread such as the firm's risk (measured by either firm-level accounting variables or the firm's credit rating), the loan facility's type (Term loan A, Term loan B, or revolver), and other facility-specific characteristics (maturity, loan size, security, etc.). The non-bank premium ranges from 21 to 76 basis points, depending on how we control for the borrowing firm's risk and other differences between loan facilities (see Figure 1). All these estimates are, however, statistically significant.

Hedge funds and private equity firms earn a premium

Furthermore, we find that the size of non-bank premium varies by the type of non-bank syndicate member and that, not surprisingly, the effect is particularly large when private equity or hedge funds are part of the syndicate. In contrast, other types of non-banks institutional investors such as insurance companies or mutual funds receive essentially no abnormal premium.

1: Average non-bank premium (basis points)
Sample Average spread Non-bank premium % of total spread
By facility type
All facility types 256.6 53.9 21.0%
Revolvers 230.1 44.9 19.5%
All, term loans 301.2 68.9 22.9%
Term, loan B only 305.8 74.5 24.4%
By issuer credit rating
All, with ratings 237.6 22.2 9.3%
BBB, and above 151.4 28.6 18.9%
BB 201.7 20.8 10.3%
B, and below 298.9 21.1 7.1%
Unrated 270.4 76.0 28.1%
Non-bank facilities have higher spreads with premiums ranging from 21 to 76 basis points.

An important consideration is the extent to which the differences between bank and non-bank tranches reflect differences in risk between these tranches. It is likely that non-bank investors tend to invest in riskier borrowers than do banks. The situation is more complex in a syndicated loan in which banks and non-banks invest side-by-side. Nonetheless, it is possible that loans containing non-bank investors could be riskier on average than loans without them.

Premiums do not reflect risks

To evaluate whether differences in risk can explain the non-bank premium, we use an approach that relies on comparison of different facilities within the same loan package. Different facilities within the same loan package are issued by the same firm, being originated at the same time and typically having the same seniority and covenants. Therefore, default risk and creditor rights attached to them are essentially the same. Then, once other facility-specific characteristics are controlled for, the incremental effect of a non-bank participant on the relative pricing gap between facilities within a given loan should reflect the impact of non-bank syndicate participation rather than underlying risk differences.

Premiums are high when capital constraints are tight

Our results suggest that the presence of a non-bank investor in a facility is associated with a higher spread, even measured relative to other facilities of the same loan that have the same default risk. When a loan package has both a revolver tranche and a Term loan B tranche and the non-bank member is present in the Term loan B portion, the spread gap between the two types of tranches is 33 to 42 basis points higher than it otherwise would be if both tranches were funded by banks only. The incremental impact of non-bank participation on the spread gap between Term loan B and Term loan A facilities ranges between 8 and 10 basis points, although such effect is not statistically significant.

...because borrowers are capital constrained

We interpret this result as consistent with the view that the non-bank institutions are providing capital when the lead bank has difficulty filling the syndicate solely from banks. The lead bank is likely to have difficulty filling the syndicate solely from banks when the borrowing firm is financially constrained and therefore traditional lenders are reluctant to extend credit to the firm. Financial constraints facing the borrowing firm would further make alternative options of financing more expensive. Using various measures of financial constraints, such as whether the firm has credit rating, whether the firm has accessed public bond market, the size of debt coming immediately due, and the 'size-age' index, we find that each measure of financial constraint is associated with significantly higher non-bank premium.This result suggests that non-bank investors can come in to fill the financing void left unfilled by traditional lenders and receive premium in return. This result suggests that non-bank investors can come in to fill the financing void left unfilled by traditional lenders and receive premium in return.

...or when supply of credit is tight

Similarly, if non-bank premiums reflect a return to providing capital at times when banks cannot, then the premiums should vary depending on the supply of bank capital available at a particular point in time. Factors that could affect the supply of bank capital include the risk aversion of banks, the overall state of the economy, as well as the demand for loans from collateralized loan obligations (CLOs). Thus, we investigate the way non-bank premiums vary year by year. Although there is significant non-bank premium in each year of our sample, there is substantial inter-temporal variation in non-bank premiums, with the premium ranging from 35 basis points in 2005 to 69 basis points in 1997 (see Figure 2). Moreover, consistent with the notion that these non-bank premiums reflect bank risk preferences, we find inter-temporal variation in non-bank premiums is closely correlated with the high-yield credit spread, which represent the compensation the market provides for holding riskier securities (and thus the degree of risk aversion of market participants).

To test whether non-bank premiums are related to the high-yield spreads more formally, we include an interaction term between the high-yield spread and the non-bank participation indicator in a regression estimating the loan spreads. We find the coefficient on this interaction term is significantly positive, implying that non-bank institutions earn a higher return for providing capital at times when banks are most reluctant to do so.

2: Inter-temporal variation in non-bank premiums and high-yield spread
There is substantial inter-temporal variation in non-bank premiums.

Another implication of the view that the non-bank premiums reflect the provision of liquidity by the non-bank institutions is that the premiums should be higher when the lead bank in the syndicate has limited liquidity itself. Consistently, we find evidence that non-bank premiums are particularly large when the lead bank lacks liquidity, measured by the lead's cash to total assets ratio or by the indicator for whether the lead is active on securitization or not.

Overall, the evidence in this paper suggests that when a lead arranger of a syndicated loan is unable to raise entire capital solely from fellow banks, it sometimes approaches non-bank institutions to help filling the syndicate. To attract these non-bank investors, the lead bank offers a higher spread. Non-bank premiums in syndicated loans appear to represent compensation non-bank investors receive for providing capital at times when filling the loan is relatively difficult.

As debt markets mature, it seems evident that non-traditional players will provide capital to a larger degree than has been true historically. Why is it optimal to have different types of investors providing the capital for the same loans? To what extent does borrower performance depend on the provider of capital? Is there important variation across banks that lead some to be more prone to co-invest with hedge funds and private equity funds in loans with higher spreads? Understanding the answers to these and related questions would be a useful direction for future research.