Keeping a close eye on downside protection

This article is sponsored by Churchill Asset Management.

How much does the mid-market space differ between Europe and North America?

Everyone has their own definition of the middle market. Even data reporting agencies who have worked in the industry for decades, have slightly different interpretations – some focus on borrower EBITDA as the determining factor; while others categorise by facility size or revenues.

The best definition for both the leveraged loan market, and sponsored transactions specifically, would be EBITDA somewhere between $10 million on the low side and $100 million on the high side – with the traditional middle market focused on the $10 million to $50 million range.

Has this changed over time, do you think?

Definitions have been consistent, though where we are in the cycle is what changes. In the aftermath of the credit crisis, large banks fled the upper end of the middle market, without a clear picture of who the natural loan buyers were, which led their underwrite-to-distribute model to fall apart.

The return of liquidity, coupled with challenging opportunities in the broadly syndicated market, and banks creeping back in, has caused credit standards to erode. Cov-lite is a perfect example of this trend for issuers in the $50 million to $100 million EBITDA range. It has also compelled larger middle market arrangers to create similar distribution capabilities, allowing them to reach into the lower end of the broadly syndicated market.

When investing in the loan market, how can one ensure better terms and better covenants on a deal?

In contrast to the large banks, direct lenders that focus on the traditional end of the middle market, have a buy-and-hold model. Churchill does not syndicate the risk off our balance sheet. Instead, we allocate it among the funds we control for our investors.

Owning the asset for the long run gives us clear appreciation of the benefit of financial tests. If issuer performance weakens, we cannot simply trade out of the asset. It requires the ability to sit around the table with the private equity owners and the borrower and work through a solution. For Churchill, these relationships are the core of our business.

In the lower middle market does it necessarily follow that there is a higher risk of default or underperformance? As opposed to a larger company?

Data show over time that default and loss rates in the middle market are actually lower than broadly syndicated loans. As counterintuitive as that may be, the reason comes down to the relationships described among lenders, owners and borrowers.

Being able to sell out of a troubled name is a double-edged sword. On one end, a fund is always on the buying end of a transaction. However, if performance continues to suffer, those holders may press for some liquidity, often to the detriment of the borrower.

Smaller lender groups, such as Churchill, are more aligned with the owner and can provide more time and a more flexible financing runway to see a company through tough times. Allowing for that value restoration has shown to reduce defaults and losses.

Are private debt managers becoming more active in how they manage portfolio investments after they’ve made the initial loan?

The management team at Churchill has been in the private credit space for decades. We have not changed the level of scrutiny with respect to our borrowers’ performance – it has always been robust. This is true for the handful of middle market club lenders we have worked with in different business cycles. Firms that have come into private credit over the last three or four years do not have that track record.

Experience working through challenging credit issues gives firms like Churchill the ability to recognise problems early. And equally important, to avoid highly cyclical companies or weak structures and terms, which can be problematic in a downturn.

What form does lender scrutiny normally take?

The scrutiny begins when the deal first comes in the door. In Churchill’s case, we have an initial screening process to determine whether or not the fundamentals of the business, and the structure of the deal, make sense within our strategy.

We have a conservative credit bent, given our long experience in the middle market. This tends to eliminate 90 percent of the deals we initially review. For the 10 percent that do make it through the first hurdle, there is extensive due diligence. We work closely with the borrower and the sponsor on all of our underwriting issues and questions to reach final approval.

Once financing closes, we rigorously monitor performance within the regular reporting governed by the credit agreement. This can mean monthly, or quarterly financials.

Have you seen a particular trend towards opportunities in specific industries in the mid-market?

Since the credit crisis, and to some extent even before that, Churchill has focused on defensive sectors; particularly healthcare, business services, software and technology. The key to our strategy is aligning ourselves with top tier private equity sponsors with decades of successful experience investing in the same industries.

This alignment ensures plenty of equity capital below our senior debt, but provides ongoing support for the company’s growth strategy, whether via acquisitions or organic growth.

Avoiding sectors that Churchill has little familiarity with, or which would be heavily impacted in a recession, has worked well for us.

In terms of deal origination, a lot depends on relationships. Are there other aspects beyond sponsor relationships that are important?

A great origination synergy we have with Nuveen, our parent company, is their portfolio of direct investments in the private equity funds themselves. Through its management of limited partner interests in those funds, Nuveen brings a special relationship that Churchill can leverage to access senior debt transactions. We’ve also raised significant capital on our platform since 2015, allowing us to hold up to $150 million per deal. This capability has up-tiered both the dialogue with our clients and the opportunities to increase our dealflow over the last several years. This differentiating strategy has solidified Churchill as a top 10 middle market lender.

What is your outlook for 2019?

This year looks to be even better for Churchill than 2018 – which was a record year. The number of firms that can combine differentiating sponsor relationships with large hold capacity will rationalise over time. There is a perception that private credit is a crowded corner, but sponsors are narrowing their key relationships with providers. With competition for buyouts as fierce as it is, private equity firms want to know exactly who they are dealing with. They cannot afford to have a lender back out or create challenges as they try to grow their businesses. We are fortunate enough to be expanding our business with great relationships and a stellar platform.