This article is sponsored by Bridgepoint Credit
The uplift in the base rate brings elevated returns, but how are you thinking about the elevated risk?
Paul Johnson: Certainly in a zero base rate environment we were lending at higher interest cover ratios than we are now. People talk about interest cover as EBITDA divided by interest, but ultimately cash pays that elevated interest, and so we really feel that the focus needs to be on cash conversion. Across all our portfolio, our cash conversion has historically been around 90 percent of EBITDA. There will also be less tolerance for mistakes in a higher interest rate environment, so it is all about the defensiveness of the portfolio that you have constructed and its ability to withstand the macroeconomic conditions of today and tomorrow.
We do think risk first, but it is also right to highlight returns because there are really attractive risk-adjusted returns in today’s market. We are now providing loans that we expect to return 10-11 percent at senior secured risk level – well inside 50 percent of the valuation of the borrower. That return is cash yield and that is what investors are telling us they are most interested in today.
What does defensive investing look like to Bridgepoint Credit?
Andrew Cleland-Bogle: We have noticed a lot of our competitors now starting to talk about a focus on investing in defensive sectors. We have always invested in the more defensive sectors of technology, healthcare and business services. But just talking about certain sectors misses the point. For example, there are many healthcare businesses that are not defensive at all. ‘Defensive’ to us means sourcing investment opportunities in resilient business models.
What does this mean in practice? It means businesses with high barriers to entry in the sectors in which they operate and strong market shares in growing markets. High revenue visibility is key, and that comes through having a diversified customer base that is sticky because the product or service on offer has a deeply embedded reason to exist for the customer.
If you have that combination, you typically have pricing power such that if you are facing wage inflation or other cost increases, you can pass most of these through. Critically, you are looking for high EBITDA margins and those high cashflow conversion metrics that Paul was talking about.
The ESG angle is also worth mentioning, because businesses with strong ESG ratings will have more sustainable valuation levels than businesses that do not. A business on the wrong side of the ESG debate will likely attract a lower number of buyers or lenders at exit of the investment, so it comes with a lot more risk.
Finally, the other element of defensiveness is growth, so we look for companies that we describe as ‘defensive with growth’. Borrowers with these characteristics will continue to attract financial buyers and maintain strong value cover for their senior lenders.
What if things do not go to plan, are direct lenders set up to deal with problems that may arise?
ACB: Obviously we can’t speak for others but we certainly have the set-up needed to manage any situations that don’t go to plan.
The first line of defence for us is using all the angles in our organisation to identify and avoid making higher-risk investments in the first place. A key thing that we see as a competitive advantage vs our peers is our money-can’t-buy network of over 300 sector specialist industry advisers. We have built this over many years, and they assist us in our due diligence on new investment opportunities. Put simply, they help us avoid mistakes.
Our second line of defence is the deep financial restructuring experience that we have in our Credit platform. We also benefit from having direct access to Bridgepoint’s dedicated operating support team, which we can deploy as we need to. That combination of financial and operational restructuring expertise means we are able to directly tackle any situations that go awry and work to maximise returns.
Finally, it is really important to have a diverse number of sponsors that you transact with. Direct lenders that do not have this may find themselves in situations where they might be worried about taking the right direct action to protect their value because of fear of reprisal. If you have a diverse pool of sponsors that you transact with, you can take the action you need to without worrying about damaging your future dealflow.
We have transacted with more than 65 different European sponsors just in our direct lending strategy alone. That strong negotiating position is our third line of defence should anything not go to plan, so we can act on behalf of our investors to do what needs to be done.
Deal volumes are reported to be down. Are you seeing this? If so, what is driving it and what is the outlook?
PJ: New deal volumes are definitely down and have been for several quarters. There are mitigants to that, with lots of private equity firms executing on buy-and-builds that continue to provide a level of dealflow even in a quiet market.
Another mitigant is that direct lending is clearly the most deliverable source of debt capital for private equity, so we as an industry are now the first call made by sponsors. That means there are lower volumes but a much higher proportion of the deals that are out there are coming to direct lenders.
The low deal volumes that we are seeing are caused by a number of things, including the tougher fundraising environment for private equity that is causing funds to make capital last a bit longer and maybe do a couple fewer deals each year than normal. There is also still a nervousness about valuations and bringing a current portfolio asset to sale and it not transacting, thereby tainting the asset.
I have been in this business well over 20 years and I have seen these cycles many times – it only ever lasts a year or so and then people have dry powder and need to start putting capital to work. So we do expect a material pick-up in activity in 2024, which is consistent with our current portfolio and where they are on their exit plans.
ACB: There is a huge opportunity for direct lenders to get the risk side of the equation right and benefit from the really attractive returns on offer. We are very excited about this because we know we have built a team of investors that are well positioned to capture these returns while continuing to carefully look after the risk in our portfolio.
What about loan-to-value; is that as important as interest cover?
ACB: I got asked at a conference recently what was more important: LTV or interest coverage, and it completely divided the panel I was on. What I would argue is that LTV dynamics are absolutely critical because if there is significant equity value in a business, the sponsor will support it to the extent it has additional capital requirements going forward, whether to pay down debt or support growth capex. Sponsors will continue to look after their investments where they believe equity value remains strong.
We have seen compression of valuations in the public markets but not in the private markets over the past 12 months. Could that be a function of the very high historical levels of private equity dry powder chasing what are right now a reduced set of opportunities? There is certainly a supply/demand mismatch.
Still, notwithstanding that, we are seeing the businesses that have these ‘defensive with growth’ characteristics attract some of the highest valuations from private equity buyers. If some of the reduction of valuations in the public markets eventually comes through to the private markets, we believe that the businesses that will be most insulated from that will be those with these characteristics.
PJ: What we do is not rocket science – we lend money, receive interest coupons along the way and then we get the loan back. Interest coverage is important but more important is getting our loan back and avoiding losses. So LTV is key because we also want to know the business is going to be worth more than we have lent.
Across our portfolio the average opening LTV in our three funds is around 35 percent. We know valuations can and will change, but with that as a starting point we have considerable room for valuation adjustments that will impact private equity returns but not our credit returns, which are largely contractual.
Paul Johnson is partner and chairman of direct lending, and Andrew Cleland-Bogle is partner and head of direct lending at Bridgepoint Credit