Crestline Investors on how flexible capital enhances outcomes in private debt

Although some portfolios may be under stress, there are more opportunities than threats for many private credit managers thanks to their ability to lend across the capital structure, says Keith Williams of Crestline Investors.

This article is sponsored by Crestline Investors

Where are you currently seeing opportunities in the private credit markets?

Keith Williams

Our products allow us to invest across a full range of opportunities, from first lien all the way up to distressed and growth opportunities.

When Chris Semple and I joined from Goldman Sachs in 2012, we wanted to utilise what we learned at Goldman’s special situations group, which drove our decision to create multiple fund strategies. The ability to move across investment strategies while looking for the best risk-adjusted return at a given time was critical.

Right now, in direct lending we are looking at senior secured and unitranche opportunities ranging from $20 million to $100 million cheque sizes, which we believe are in a less competitive part of the lower-middle and middle market. In the opportunistic credit business we have a lot more flexibility: we can make first-lien loans, buy distressed assets or we can take advantage of areas of dislocation or market inefficiencies that arise more quickly.

In each strategy, we are focused on top of the capital structure risk, so we typically invest through a senior secured structure or own assets without leverage. These situations have been robust, given what is going on.

The portfolio finance strategy provides capital to private equity funds, either in the form of a loan or preferred equity using the fund’s net asset value as collateral. At a time when PE funds are in need of additional capital later into their fund lives, that’s an area where we are seeing a lot of attractive opportunities.

We think in general the private credit outlook is strong, though it varies across the credit spectrum. Not all asset classes are good all the time, but we see higher pricing, lower leverage and tighter structures benefiting private lenders. Some market participants such as BDCs and certain direct lenders are constrained by existing portfolio issues, which means fewer market participants. We expect the big guys to continue to get bigger, thus pushing them to write bigger equity cheques. We think this will ultimately lead there to be less competition at the lower end of the market. Regardless of fund size, differentiated sourcing will be key. M&A volumes will undoubtedly be down, so the traditional model of waiting for sponsors or investment banks to call will not be as effective.

How has working from home fundamentally changed your business model in terms of sourcing investments and raising capital?

As a team, we are used to travelling and working remotely so our systems stand up well. From a sourcing perspective, we initially focused on those investments where we met the management team pre-covid-19 or companies or individuals we have worked with before. We have yet to close a new deal with a company where we have not met the management team in person, but we do have multiple term sheets signed with those types of situations. We would like to see them, whether we travel to see them or they would like to come see us. Regardless of the venue, we will obviously take all the appropriate precautions.

A lot of our sourcing is anchored around specific industries where we have been actively investing for over a decade. These industry-specific relationships, including consultants, board members and C-level executives, plus more traditional relationships with private equity funds and investment banks have enabled us to have strong sourcing through the pandemic.

Given how quickly the market has moved around, people initially focused on liquid opportunities, and anything that wasn’t liquid was hard to sell. Since then, much of the market has been focused on stressed and distressed opportunities. But given how quickly everything is moving around, having flexible capital that can move across different areas of market dislocation is proving really valuable.

How have portfolio companies been holding up through Q2?

Thus far, our portfolio companies have generally fared well through Q2, given the environment. At the outset, we had built a defensive portfolio, with exposure in healthcare, business services, software, education and asset-backed transactions.

We generally do not like cyclical or consumer discretionary risk and our portfolios are diversified. Industry diversification and single name exposure limits are key risk mitigation tools in our portfolios. Likely most importantly, we also maintained a significant focus on investing at the top of the capital structure, which provides us with protection and flexibility during potentially difficult times. It’s worth noting that about 25 percent of our investment team previously worked in the restructuring industry and we think that will continue to add value.

We have a few multi-site healthcare deals, and during the crisis those entities were closed for a period of time. But they have all recovered pretty quickly. Today, many companies’ rates of recovery depend on the type of consumer exposure and where companies are geographically.

Going into Q3, given what we just went through, we think our portfolio companies are well positioned to endure the current environment. However, we must be ready for a continued covid-19 impact and what impact it will have on the portfolios. We continue to stress test our portfolio companies to determine the level of revenue and earnings deterioration as well as potential liquidity needs.

How are your investment assumptions changing due to covid-19?

The assumptions vary based on industry, end markets, geography and other nuances. At this point, we must assume that a second wave will come because it would not be prudent to naively underwrite otherwise. So, we are assuming deterioration of the top line, EBITDA or underlying asset level.

We must verify that companies and their investors have the resources in place to withstand round two, which then dovetails into opportunities. Investors are generally going to see a flight to quality, so those things not impacted by coronavirus – or feeling a limited impact – will be much more competitive deals. It is going to be a new normal and we are going to have to underwrite the various ways covid-19 may impact businesses and assets and appropriately structure and price for the risk.

Keith Williams is managing partner for opportunistic and credit strategies at Crestline Investors