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Direct Lending Overview

SDCERA | Opportunity Fund: Credit Opportunities 2

Middle Market Direct Lending Defined

Primarily first lien senior secured floating-rate loans to U.S. middle market companies that otherwise lack access to capital

– Term loans typically with a 5 to 7 year maturity, but loans often paid down within 2 to 3 years– Middle market companies (no standard definition of ‘middle market,’ but typically have EBITDA

<$50MM)• Loan sizes typically between $20 - 200 million with an emphasis on lower loan sizes

– Directly originated loans as opposed to broadly syndicated deals• Companies are too small to access the high yield or broadly syndicated loan market

– Senior secured: typically by cash flows (i.e., companies are owned by private equity firms), and to a lesser extent by assets

• May include “unitranches” (combine first lien and mezzanine)– Floating-rate off of LIBOR, usually with a floor– Illiquid: “originate and hold”; not actively traded– High single digit / low double digit expected total returns, depending primarily on the collateral

focus of the manager and/or use of portfolio leverage– Primary risk is credit impairment

Expected Total Returns for LPs of high single digits/low double digits, depending primarily on the collateral focus of the manager and/or use of portfolio leverage. Please note there are significant differences in managers’ Expected Returns.


Significant Decline in Middle Market Lending Base

Source: CIT

Historically, the direct lending market has been dominated by– Collateralized Loan Obligations (CLOs; largest holders)– Regional banks– Specialty finance companies (GE Capital, CIT, etc)– Hedge funds S&P estimates that over 150 lenders were competing for middle market loans in 2007– According to BlackRock Alternative Advisors, 85% of those lenders have since exited from the

marketCLO issuance declined from $80 billion in 2007 to $5 billion in 2010No clear size on the market; estimated by S&P to be $15.5 billion, while other estimates are significantly smaller


Direct Lending: Loan Structure

Source: Standard & Poor's

Typical StructureSenior Secured, First Lien Maturity 5-7 year with 2-3 year average durationSize $20-$200 million Leverage 2.5 - 4X EBITDAAverage Loan-to-Value (LTV) 47%Not rated by agenciesManagers structure covenants (max leverage, min EBITDA, max capital expenditures)

Typical Pricing/Sources of ReturnFloating rate off of LIBOR usually with a floorCoupon or “Stream Rate” L+450 to L+700 (~5.75%-8.50%) varies depending on collateral and leverage. Primary source of total returnAdditional fees (origination fees, prepayment fees, modification fees) can average 2-3%Some deals may have upside through PIK interests, warrants, etc. (depends on manager’s approach)Capital appreciation is typically not a source of total return

Amount

Multiple of

EBITDA

% of Capital

Staructure (LTV)

Senior Debt $94.3 MM 3.8x 47%

Mezzanine $18.5 MM 0.7x 9%

Total Debt $112.8MM 4.5x 56%

Equity $89.2 3.6x 44%

Total Company Value $202 MM 8.1x 100%

EBITDA $25MM


Less Liquid More Liquid

Fund Term Ten years Five Years

Investment Period 5 – 6 Years 2 – 3 Years

Management Fee 1-2% on drawn capital 1-2% on drawn capital

Incentive Fee (carry) 10 - 20% 10 - 20%

Preferred Return 5% - 8% 5% - 8%

Liquidity Provision None 90 days notice – liquidity provided as loans repaid

Claw back Yes Yes

Distributions: Quarterly of Income Quarterly of Income

Recycle Provision: Yes – for investment term Yes

Sharing of Fees: Yes – but devil is in the details Yes – but devil is in the details

Leverage Available: Yes Yes

Direct Lending: Vehicles Span the Spectrum of Liquidity and Structure

Please note there are significant differences between vehicle structures across managers.


Comparison: Bank Loans vs. Direct Lending

Bank Loans Direct Lending

Lending BaseLoan size

Large>$250mm

Middle Market (EBITDA <$50mm)$20 - 200mm

Structure Syndicated Direct Origination

Terms Floating-rate : LIBOR + spread Floating rate : LIBOR + spread

Liquidity Liquid: trade OTC Originate and hold; no trading

Maturity 6-8 years 5-7 years

Duration 2-3 years 2-3 years

Secured By Assets Cash flows/Assets

Drivers of Total Return - Coupon (LIBOR + spread)- Capital appreciation (limited)- Losses from defaults

- Coupon (LIBOR + spread)- Fees (ex. origination, pre-payment)- Losses from defaults

Expected Return 5% annualized 1 7-12% annualized 2

Primary Risks Borrower Default Borrower Default

Default Rate Long term average ~4% Lower than broadly syndicated

Historical Avg. Recovery Rates 66% of Par 80-90% of Par

Management Fees 50-70 bps 100-200 bps

Incentive Fees -- 10-20%

1 Based on HEK 1Q2013 CAPM assumptions; 10-year projections and are revised quarterly by the HEK Investment Policy team2 Reflects our performance expectations for such strategies given managers on our approved list


Direct Lending: Lower Default Rates, Higher Recovery Rates

Cumulative Institutional Loan Default Rate by Deal Size(1995 – 2009)

Recovery Rate by Loan Class1

Source: S&P Source: S&P LSTANote: (1) Reflects ultimate recovery rates for the period 1989 – 2009.

Middle Market Loans historically have had lower default rates and higher recovery rates than loans made to larger companies. Not surprisingly, the recovery rates are higher than instruments lower in the capital structure


Comparison: Unsecured High Yield vs. Direct Lending

High Yield Direct Lending

Structure Syndicated / fallen angels Direct Origination

Capital Structure Junior in the capital structure Seniority in the capital structure

Terms Fixed rate Floating rate : LIBOR + spread

Liquidity Liquid: trade OTC Originate and hold; no trading

Secured By Unsecured Cash flows/Assets

Drivers of Total Return - Coupon (fixed rate)- Capital appreciation- Losses from defaults

- Coupon (LIBOR + spread)- Fees (ex. origination, pre-payment)- Losses from defaults

Expected Return 4% annualized 1 7-12% annualized 2

Primary Risks Borrower Default Borrower Default

Default Rate Long term average ~4-5% Lower than broadly syndicated (~ 4%)

Historical Avg. Recovery Rates 40% of Par 80-90% of Par

Management Fees 40-80 bps 100-200 bps

Incentive Fees -- 10-20%

1 Based on HEK 1Q2013 CAPM assumptions; 10-year projections and are revised quarterly by the HEK Investment Policy team2 Reflects our performance expectations for such strategies given managers on our approved list


Direct Lending: Summary

ProsCurrent market dynamics are favorable for direct lending

– Size of lending base has significantly decreased since 2007Direct lending offers attractive risk and return characteristics

– Expect high single digit / low double digit total returns– Provides good current income stream– Quality substitute for traditional fixed income

ConsThough the space is favorable, other considerations must be addressed

– Manager selection is critical to success• No industry standard terms or structure• Notable differences in manager return expectations (depending on collateral and upside

participation)– Relatively small universe of managers– Opaque, private market– Investors must be willing to accept illiquidity; strategy thought of as “originate and hold” – Asymmetric return profile – i.e. yield/income is the primary source of total return; little potential for

capital appreciation


Appendix


Middle Market Loan Spreads versus Large Company Leveraged Loans

Source: S&P

Average Nominal Spread of Leveraged Loans

Since 2008 the spread on middle market loans has been approximately 100 bps wider than large corporate loans and has continued to trend higher. As of June 2012, spreads on middle market loans were 612bps while spreads were 443bps for large corporates


Middle Market Leverage versus Large Company Leverage

Source: S&P

Average Nominal Spread of Leveraged Loans

Since 2005, the middle market leverage has been less than that provided to larger companies


Higher Annual Returns in the Middle Market

Annual Returns: Middle Market Loans vs. Large Corporate Loans


Broadly Syndicated Bank Loans vs Direct Lending vs Mezzanine

Broadly Syndicated Bank LoansAlso known as Leveraged Loans or Par LoansLarger deal sizes, typically >$250 million with many $400-700 millionTypically syndicated by an investment bankTrade on an OTC basisGreater mark-to-market volatilityTypically no prepayment fees or other penalties that are accretive to Total ReturnSame maturity and average life as direct lendingSame floating rate characteristics as direct lending

Mezzanine• “Mezzanine” refers to the level of a portfolio

company’s capital structure between senior debt and common equity. It is junior in the capital structure to bank debt and high yield

• Greater upside because of possible equity participation

Source: SilverCreek

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