In an era of increasing inflation and rising interest rates (including Wednesday’s half percentage hike by the US Federal Reserve), Bain Capital Credit remains attracted to mid-market companies, explains Michael Ewald, global head of private credit. The interview is part of affiliate title PE Hub’s ongoing series of Q&As with high-profile private equity dealmakers.
What are your expectations for mid-market PE deal activity in 2H 2022 and beyond, as rising inflation and rates continue to loom large?
Right now, we are seeing the collision of sponsors sitting on plenty of dry powder to invest against the backdrop of a slow growth economy with rising rates and increasing inflation. The uncertainty around growth rates could temper buyers’ enthusiasm and create a disconnect with sellers. PE sponsors may have certain price expectations for their exits based on past comparable deals for similar businesses, and buyers might not be willing to pay that premium because of muted growth expectations. This could result in sponsors opting to hold onto their companies for a bit longer to show they can operate well in this sort of economic environment. So, for the remainder of 2022, we expect dealmaking to continue to be steady, but unlikely to be record breaking like 2021. In terms of sector dealflow, a year ago, “reopening sectors”, or those with a consumer focus, were in favour, but today we’re seeing more activity in defensive sectors, such as technology, healthcare and business services, somewhat similar to what we observed during 2020.
What do you make of the trend of the upsizing of facilities in private credit with unitranche loans getting bigger?
Private credit, direct lending and mid-market lending used to mean the same thing. That is clearly no longer the case with the increasing popularity of larger, directly originated loans. It’s important to note, though, that while these loans are directly originated, it’s really not mid-market lending since they’re typically being utilised by larger borrowers. The market has seen an increase in credit fundraising from large-cap firms who are now deploying capital outside the traditional mid-market. There is often a correlation between larger fund sizes and bigger deals, so it’s not surprising these players would look to participate in billion-dollar plus unitranches. From a PE sponsor perspective, unitranche financings offer several advantages to a syndicated loan, including perhaps, most importantly, the ability to quickly close deals with the speed and certainty that’s required in today’s competitive marketplace, as buyers continue to try to distinguish themselves through the pre-empting of auctions.
Walk me through your rationale for not participating in these large financings and instead focusing on the mid-market?
We see most of the large unitranche deals that tend to generate headlines, but we have not been active participants in these types of financing. We remain attracted to the core mid-market – what we consider to be companies with $25 million to $75 million in EBITDA – because these companies tend to be nimbler and have a business model that is niche enough that it won’t ebb and flow just with its industry or the broader economy. Serving as a lender to these mid-market businesses also affords us the ability to control and own the entire tranche and set appropriate financial covenants. Jumbo unitranches are typically club deals involving several firms, which doesn’t allow lenders much, if any, control. We see this often leading to borrower-friendly structures such as covenant-lite loans with lower pricing. In addition to more balanced terms and structures, we believe the mid-market offers steadier dealflow.
Private credit is floating rates so it still may be an attractive asset to investors in a rising interest rate environment. But how does the broader macroeconomic backdrop change the way you and other lenders are thinking about deploying capital?
Growth is certainly something we’re playing close attention to, although it is less of an issue for private debt providers than it is for PE sponsors. It also makes the exit math a bit more challenging, notably necessitating lower exit price multiples and longer hold periods. The prospect of inflation and rising interest rates, presumably even above the Fed’s latest hike, hasn’t changed how we think about investing capital nor our investment approach. We have the benefit of being able to leverage Bain Capital’s global platform to maintain our selectivity and discipline when choosing which new investment opportunities to underwrite. We enjoyed an active 2021, having invested nearly $3 billion across more than 100 portfolio companies, and we’re encouraged by our current pipeline.
Given the heightened competition in the space, how is Bain Capital Credit navigating the easing of underwriting standards from some lenders?
That’s certainly what you’re seeing in the large cap space as private credit providers try to compete with the broadly syndicated loan (BSL) market for deals by offering these larger unitranches. While the BSL market tends to feature lower pricing and looser documentation, we’ve found that’s less the case in the core mid-market, which is another reason why we remain focused on the space. Importantly, we have not diminished our underwriting standards despite increased competition. We’re also not afraid to say no to deals we don’t have conviction in. At Bain Capital’s private credit group, we look at around 700 deals a year, and we close a single digit percentage of those. Our primary objective is to be the partner of choice for performing mid-market and private equity-backed companies with stable operating models and strong growth prospects.
Do you believe the growth in private credit has created too much leverage in the system?
Not necessarily. I would say it is more that private credit has displaced other sources of capital especially in the large-cap market and BSL market. In the core mid-market, lenders have taken share from regional banks and specialty finance companies, so in that sense no. I think the pandemic, particularly the second and third quarters in 2020, provided a great case study. The banks lending to private credit portfolios like ours didn’t panic; portfolio companies held up well; and PE sponsors did an admirable job of managing their companies through the heart of the pandemic. Sponsors went right to management teams and said, “We have to cut costs and reduce capital expenditure to be able to weather closures or zero revenue quarters.” If we can handle that kind of shock to the system, it’s hard to argue there is too much leverage in the system. Leverage is also just one way to measure risk. Our loan-to-value is lower now than it’s ever been – well below 50 percent in most of our deals – compared to being closer to 60 percent in 2007/08, mainly because we haven’t chased leverage multiples up as high as enterprise value or purchase multiples have risen.
This article first appeared in affiliate publication PE Hub