This article is sponsored by Comvest Credit Partners
It may be counter-intuitive in the midst of a pandemic but Comvest Credit Partners, a mid-market investment manager headquartered in Florida, sees this as a great time to be doing business. Three leading professionals at the firm explain why.
What are your thoughts on dealflow?
Daniel Lee: Volume dried up in mid-March and remained subdued for several weeks as uncertainty seized the market. Despite the slowdown, we maintained an active origination effort throughout and are starting to see interesting opportunities emerge as local economies reopen. We’ve been issuing term sheets, signing letters of intent, and closed two deals. We expect a nice increase in volume going into the second half of the year. Many of our competitors have pressed pause on new investments and are waiting for more information regarding how covid-19 will impact the economy in the medium term. We recognise that economic uncertainty is high, but there are many businesses seeing minimal to no impact from covid-19, and some that are benefiting. We don’t want to arbitrarily pass on attractive opportunities, especially when we’re able to build so much margin for error into our deal structures.
Tom Goila: We’ve also observed a barbell effect in the current market. On one side, we’re seeing a lot of distressed opportunities. We look at those, but they’re not our focus. On the other side of the barbell are really high-quality companies that have not been as affected by covid-19. As the market stabilises, we expect some more ‘regular way’ businesses, but right now the majority of dealflow is comprised of those distressed situations and companies unaffected by covid-19.
How is liquidity – or lack of it – factoring into the competitive environment?
TG: From a private equity perspective, things are all over the map. Many private equity sponsors have stepped up to help their well-performing portfolio companies. Other firms may have inadequate capital and are being forced to triage their portfolios to decide which companies to support. In particular, older investments may face issues if they sit in legacy fund vintages with no remaining capital.
In situations where an equity sponsor has decided not to support a portfolio company, it may fall on the lenders to make the determination. Then the question is whether the lenders have sufficient liquidity to support these borrowers. Lenders with meaningful exposure to industries in distress (eg, oil and gas, retail, travel, etc) may need to triage their portfolios in the same way as equity sponsors. This domino effect is why a lot of lenders are frozen out as they wait to see how their liquidity profile will develop.
How have terms and pricing changed?
Robert O’Sullivan: The past five-plus years have been a borrowers’ market. Spreads have been on a steady decline. I think we reached 20-year lows in some markets just before covid-19. But more troubling has been the weakening of credit agreements and dilution of terms that are so key in this business. Even simple terms have got stretched and weakened, including the definition of EBITDA, cash hoarding provisions, and the definition of ‘use of proceeds’ for delayed draw facilities. These things were negotiated out of credit agreements and it’s coming back to haunt many lenders that got used to saying ‘yes’ to everything. That’s the price they will pay for compromising on discipline to build market share.
We are finally starting to see that relationship change as more discipline comes back into the lending market. I think it’s fair to say lenders are being more cautious and demanding better structures in the current environment. We expect this dynamic to last for some time. There is no doubt senior secured loans with good financial covenants will lead to better recoveries and lower losses.
DL: I think those trends are becoming clearer in the pricing and structures of recent deals. For sponsored lending deals, we saw leverage decrease about 1.0x to 1.5x on a comparable credit as a result of covid-19. Pricing increased between 150 and 300 basis points and other loan terms also improved. But it’s hard to make generalisations because of relatively light dealflow in April and early May. More recently in sponsored lending, we’re starting to see deals coalesce around a 100 to 200 basis point improvement in pricing and one turn of leverage reduction. In non-sponsored lending, we see even more attractive lending terms because that market is less crowded, but that’s nothing new.
How do you assess the opportunity in these unprecedented times?
ROS: We focus on industries where we have experience. As a result, we are not lending to oil and gas, real estate or heavily consumer-driven businesses. In reality, no one can forecast the next six or 12 months with precision so we’re looking for situations where we can bring that experience to opportunities in our focus industries where we already have strong relationships and know the landscape. We can structure the risk conservatively and get paid a premium because we’re open for business when other providers are dealing with liquidity issues.
DL: Looking forward, we expect and are preparing for a slower-than-expected recovery in the second half of the year and 2021, whether there is a second wave of covid-19 or not. Government stimulus and aggressive cost cutting by companies have bought time, but fundamentals have still deteriorated substantially. We expect that the market will start to feel the weight of unemployment and covid-19 repercussions, which will ultimately outweigh the positive effects of reopening. As a result, we expect that lenders will experience increasing defaults through early 2021. This ‘rolling wave’ of defaults could extend further into the year, especially if there’s a second wave. Given these expectations, we’re being very thoughtful in deploying capital.
How do you view the opportunity in non-sponsored lending, and with independent sponsors?
TG: The importance of underwriting is amplified in non-sponsored lending because there’s no equity sponsor to inject capital if something goes wrong. Those sponsor capital injections are a form of credit enhancement as far as we’re concerned. There’s also no private equity diligence to rely on, so we need to administer ‘private equity style’ diligence ourselves. And going back to an earlier point, we need to understand alignment and who can provide capital in times of stress. It may be a founder, an independent sponsor or the lender. We use that lens right up front.
DL: The non-sponsored market has been a target for us since the beginning. We’ve seen some other lenders enter the space over the past decade but it’s not nearly as crowded as sponsored lending because it’s smaller and so much harder to access. Having a private equity arm gives us the resources and knowledge to underwrite these deals and that’s hard to replicate for many traditional lenders. But the added work comes with tangible benefits: transaction terms (including pricing) and structures are generally better and more stable through a cycle.
While relatively less crowded, non-sponsored lending is still competitive. In terms of winning the deal, we bring resources and experience to the table that a generalist won’t have. We need to demonstrate to an independent sponsor and the management team that we can help them make strategic connections and enhance their business. We can bring our industry specialists or operating partners to a meeting to convey that there’s more value in our investment than just the dollars. And borrowers have higher confidence that we can close the deal because we already understand the nature and risk elements of their industry.
How does having industry specialists help you with portfolio companies?
TG: Healthcare is a great example. There’s so much going on right now, and those dynamics are different across sub-sectors. For instance, Medicare has changed its policies to help providers and we have a real expertise there. We’re able to work with borrowers to modify agreements and ensure they work in conjunction with those recent policy changes. If you don’t understand the industry or aren’t familiar with those recent reimbursement modifications, there may be unnecessary delays and expenses. Embedded industry knowledge doesn’t just help us close the deal, it can make a real difference over the life of an investment. You can’t be a ‘tourist’ investor in these industries.
How do you go about preparing your portfolio for a crisis?
DL: Fortunately, we’ve remained conservative on our loan terms and focused on industries that we know well. We have also tried to work with borrowers that value communication the same way we do. When we’re competing against someone who’s willing to offer a looser structure than us, we emphasise to the management team or sponsor that we view covenants as communication. It’s our way of agreeing from the outset when we need to dial up the communication to navigate a challenge. We want to have an open dialogue, which we believe is imperative for a healthy and productive relationship. This also equips us to be a better partner during times of stress because we’re already tuned into the business.
By focusing on these simple elements, we’re able to build a portfolio that’s better prepared to weather challenging times. We’ve seen this play out during the covid-19 crisis as conservative underwriting and constructive borrower communication have helped us navigate the current challenging environment with borrowers and help them prepare for potential opportunities on the other side.
Robert O’Sullivan is co-founder and managing partner, Daniel Lee is a senior partner and Tom Goila is a senior partner at Florida-based fund manager Comvest Credit Partners