What is the current state of US mid-market direct lending?
It is an attractive alternative for investors these days because the relative value of the asset class has become pronounced despite excess liquidity in the market. Because the middle market is so large and fragmented, it offers potential opportunities to generate better returns in transactions with more conservative structures at a time when most assets are very expensive.
We focus on the private equity part of this market and lend to companies operating across a wide range of industries. This segment is very active, with M&A activity driven by the significant funds raised by private equity firms to invest in mid-sized US companies, and with demand increasing for refinancing of existing transactions. These are large markets with some new players over the past few years, but significant barriers to entry remain.
Direct lenders are competing fiercely in this market. How do you deal with this?
Assets in most markets are expensive as there is a lot of investment capital and liquidity, as well as continued confidence in the underlying economy. Multiples paid by private equity sponsors when acquiring businesses have risen, and there is a lot of capital targeting the middle market, so pricing, leverage and covenants have been under pressure for some time. Over the past few years total debt-to-EBITDA in our markets has risen to 5 to 5.5 times on average, while senior debt is around 4 times.
Direct origination is a key differentiator for NewStar. We originate our loans directly with our borrowers, as opposed to buying them from others in the more liquid markets. This enables us to conduct extensive first-hand due diligence and to understand the companies and their risks in greater detail. We focus on the most successful private equity sponsors and have built relationships with them that result in repeat business. Our broad-based origination capabilities enable us to be very selective.
“In my opinion, it’s an important time to be cautious and invest with the most experienced and conservative managers”
In my opinion, it’s an important time to be cautious and invest with the most experienced and conservative managers. We are one of the very few managers with experience through the global financial crisis and our investment strategy and strict underwriting discipline are among the most conservative in this market.
In what ways are you conservative?
First, we focus on senior debt. The definition of senior debt can be confusing to investors because the characteristics and ratios have been stretched. For us it is very straightforward. Number one, senior debt is on top of the capital stack. If we call it senior debt, it has no debt in front of it, including bank revolvers. A bank loan in the form of a revolving credit facility may seem small, but if there is a problem and the bank has control over cashflow, that may change the outcome and increase the loss in the event of a default. For the same reason, if a lender does a unitranche deal and sells the first-out portion, it has turned itself into a subordinated lender.
Number two, we consider loans with more than 50 percent of real value to be stretch loans that are taking some risk beyond pure senior debt.
In addition, we generally focus on established companies with at least $15 million in EBITDA that operate in select industries. We do direct due diligence and we get financial covenants in more than 90 percent of our transactions. We know that we have to be a little more flexible in this market, but we continue to be relatively strict about negotiating covenants and other lender protections.
Is this preference for pure senior debt a particular preference at this point in the cycle, or a general structural preference for you at every point in the cycle?
The answer is “yes” to both questions. We have always focused first on preservation of capital and, therefore, on mostly senior, secured debt, even though that costs us some yield. In this market our views are reinforced by the fact that spreads for subordinated debt seem less attractive on a relative basis because there is so much money chasing yield. Leverage, terms and pricing are aggressive on most investments, and, although we are bullish about the US economy, we are concerned about increased volatility. Certain sectors are under pressure, rates are up and inflation will impact margins for some borrowers.
Another way of reducing risk is to lend to good companies. What kind of business do you like?
First of all, we like lending to private-equity-sponsored firms for a number of important reasons. Sponsors invest significant cash equity in their portfolio companies; they typically have valuable experience in the borrower’s industry; they do extensive due diligence; and, probably most importantly, if there are issues with the borrower, we know that we can work with the owners at an early stage in an effort to protect both their investment in the company and our loan.
Our portfolio is very diverse in terms of industries and reflects a cross-section of the US economy. This includes business services, consumer products and manufacturing companies, as well as companies in more niche areas, such as insurance brokerage, specialty chemicals and healthcare.
“Leverage, terms and pricing are aggressive on most investments, and, although we are bullish about the US economy, we are concerned about increased volatility”
In all sectors, we prefer companies that are leaders in their markets. They are established businesses that have typically been around for more than ten years and operated in the last cycle. They have at least $15 million in EBITDA, and have a diverse customer base as well as repeat business from longstanding customers. We specifically like to see substantial free cashflow, after capex and taxes, and an ability to amortise debt.
Aside from an even greater focus on senior debt, has your lending changed in response to a sense among some observers that we are quite late in the credit cycle?
We have managed credits through a variety of cycles and always worry about the next one. While we don’t see a downturn in economic growth in the near term, we underwrite every deal assuming there will be a cycle in order to get comfortable that the company has the ability to service our debt in the event that sales decline for any reason.
What kind of returns can you achieve in middle market lending?
Spreads have been under pressure for some time and currently average approximately 500 basis points above LIBOR in our target markets. With LIBOR about 2.25 percent, plus an upfront fee that adds about 35bps, the loans yield above 7.5 percent annually – and that’s for senior debt.
Has your investment approach changed following the acquisition by First Eagle?
The integration worked extremely well because we have similar investment philosophies and we kept our longstanding team in place. First Eagle has been in business for over 150 years and, like NewStar, has always emphasised patience and investing with a margin of safety that is intended to prevent permanent impairment of capital in its investment strategies.
In addition to shared investment philosophies, First Eagle brings a wide range of management, industry and market expertise, as well as scale. For our borrowers and our investors, we believe the merger means one plus one equals three.