This article is sponsored by Churchill Asset Management
The uncertainty caused by coronavirus is playing havoc with public markets, slowing economies globally and pushing some markets closer towards recession, and at a time when credit agreement terms have become looser and skewed significantly in borrowers’ favour. Vicky Meek speaks to Randy Schwimmer, senior managing director and head of origination and capital markets at Churchill Asset Management, to gauge the pulse of the US mid-market and gather his views on where the market is heading.
How is sentiment currently in US mid-market lending?
The market has been asking for years what exogenous risk could trigger the next recession. There have been plenty of candidates, from fears of a bubble in an asset class to trade wars. Covid-19 came out of the blue and its effect has been magnified by massive shifts in globalisation and China’s increased role in the global economy. The huge level of uncertainty has driven extreme volatility in public markets. Until the course and impact of the disease is clearer, we expect market swings to continue.
That said, for private credit, and direct lenders, it’s business as usual in many respects. Our business is not correlated to the broad syndication and liquid markets. We have locked in capital and are buy-and-hold lenders, so volatility is of less concern. Private credit is a closed system, with spreads and terms determined, not by fund flows, but by supply/demand. Private equity supply and private credit demand has remained consistent throughout this period.
Has LP sentiment shifted?
This is a new risk whose impact is unclear. LPs accordingly are asking many good questions. The main concern is the impact of the virus on managers’ portfolios. This is an exercise we went through recently with our own investments related to the effects of a China-US trade war. As was the case then, we’ve found minimal consequences to this event. By design, our portfolio companies have very little exposure to China. And we don’t invest in sectors impacted the most by the coronavirus, such as travel, leisure, airlines, hotels or retail. Regardless, we remain highly focused on monitoring any changes to this situation as they emerge.
Where are we in the cycle? Is a recession now inevitable?
No one yet knows the answer to that question. Covid-19 will run its course, but we don’t know how long that will take. Also, is it a recurring virus and how long will a vaccine take to develop? Before this happened, the US economy had pretty good steam. No one noticed, but the February job numbers were pretty good. It’s also now a rate cycle. The low levels of Treasury rates are breath-taking, and the US Federal Reserve has opted to throw in the towel early in the hope of staving off a worse scenario. We’ll see if that works.
We’ve been preparing for a recession for some time now. Our investment committee members operated successfully together through the Great Recession. Accordingly, every investment we make needs to pass a projected recession scenario, regardless of what causes it. Cycles aside, we have witnessed and are cautious of weaker creditor protections and leaky EBITDA definitions, particularly at the larger end of the mid-market. It will be interesting to see if the current crisis puts some of these investor-unfriendly terms on hold.
So how concerned are you about weaker terms in private credit?
We don’t do covenant-lite loans; all our investments have maintenance covenants. Wider covenant cushions (covenant-loose) seem to have plateaued at around 35 percent between the projected leverage ratio and the actual test. That gives private equity sponsors the flexibility to manage the growth of the businesses they support.
The number one credit concern for direct lenders is how EBITDA is defined. It carries through the entire credit agreement. Sponsors are paying on average 11x EBITDA for mid-market properties. That’s a record high. To make returns work, buyers are making smaller add-on acquisitions at lower purchase price multiples to average down their effective entry multiple.
The more add-ons, the greater the execution risk, and the more dependent on various EBITDA income adjustments and cost addbacks the sponsor becomes to meet their cashflow targets. As a result, we believe market-wide leverage is understated. If we move into a recession, regardless of the cause, some managers, particularly those with no experience through a cycle, will find their portfolios challenged.
Given this, how do you mitigate the risk of weaker terms generally in the market?
One of the benefits of our platform is our relationship as an LP with more than 100 GPs through our fund investment business. For these sponsors, we are more than a credit provider; we are often on their advisory boards.
That alignment of interests benefits not just our deal sourcing, but it’s critical to managing portfolio risk. When problems arise, there’s a real incentive for the sponsor to help us work those problems out. Otherwise, we are very comfortable turning deals down. Our selectivity ratio is very low. If terms or structures are weak, or it’s not a business we like, we have plenty of better things to invest in. Direct lending isn’t a sprint. We just want all our horses to successfully finish the race.
You recently folded the Nuveen junior debt and private equity teams under the Churchill brand. What was behind that decision?
It’s been five years in the making and it formalises the close relationship with the Nuveen team we’ve had since 2015. The private equity and junior debt team, led by Jason Strife, comprises ‘mezz’ investments, equity co-investments and the fund-of-fund business.
Now, with Churchill’s senior lending team, we’re truly a one-stop, up-and-down the capital structure provider under one brand. Everything from first-lien and unitranche, to mezz and second-lien. Add to that fund commitments and deal equity alongside GPs, there are few other players providing that kind of holistic private capital solution, with scale.
What’s your outlook for the US mid-market lending space through 2020?
As coronavirus plays out in the second quarter and the US election gets closer, we expect volatility in the liquid markets to persist. Against this backdrop, private credit will continue to distinguish itself.
For investors, it remains an excellent long-term investment uncorrelated to market swings. Senior secured loans are atop the capital structure with at least half in private equity capital below. That’s a ratio in our portfolio that’s remained consistent over time.
The current crisis is proof that no one can predict future exogenous risks. So, we focus on what we can predict: that lending to high-quality companies with strong free cashflows, managed by the best sponsors, is the best formula for a well-constructed loan portfolios for the long run. If issues arise, as will happen, we’re aligned with those sponsors to maximise value and protect our investments.
Looking beyond today’s story, as challenging as it is, there will be significant opportunities for long-term, well-capitalised private credit managers like Churchill, backed by the resources of a global investment giant like Nuveen, to pick up the pieces. It’s actually a very exciting time to be working on behalf of our investors to deliver real value.