Mid-market lending report: Varagon Capital on the US market

What are the private debt needs of the average sponsor-backed US mid-market company? 
You have to put that in the context of what is today’s market versus what was yesterday’s market, and how private equity sponsors are winning transactions in a competitive environment. Sponsors today are requiring that lenders be able to provide large commitments, multiple structure alternatives and flawless execution in order to lead their transactions. And they’re reaching out to a smaller number of close lenders early in their investment process to have an advantage in competitive situations. Varagon is well-positioned for this due to our lending capabilities, underwriting experience and deep relationships Sponsors know that we’re a dependable partner with capacity to support future growth.

How has a competitive environment impacted borrowing levels?
It’s clear that sponsors are frequently being forced to pay higher valuations and that an influx of capital into the private debt market has helped drive more aggressive terms and conditions. The first ask of a sponsor today is frequently higher leverage than traditional norms, as well as flexibility in documentation that, in most cases, is intended to facilitate growth strategies.

It’s critical to distinguish between the high quality business with a substantial equity cushion and the deals that simply have lower risk-adjusted returns than we’d like to see. We have to look at each investment on a case-by-case basis to determine what leverage is warranted and we have to be selective about the flexibility we allow into documentation.

What provides lenders comfort when lending under these scenarios?
In our view, there’s no substitute for deep underwriting by a team with experience over multiple cycles. It’s why we’ve built such a rigorous deal process at Varagon and why we’re so focused on being the lead lender. Lead lenders have a real advantage in seeing deals first and being in the driver’s seat for diligence, structuring and negotiation. We also value the experience of our sponsors, particularly if it’s an industry where the sponsor has a track record of execution. We partner with sponsors we trust and that have a reputation for supporting portfolio companies.

How do lenders navigate a market like this?
Your overall selection of the situations you’re willing to lend in has never been more important. We rely on disciplined underwriting that’s focused on fundamental franchise value. We’re also targeted in how we source investments. We’re working with high-quality sponsors where we have long-term, institutional relationships. We need to see that sponsors have industry expertise and a strong track record that includes, when it happens, supporting companies through underperforming situations.

One thing that we’re very aware of is the EBITDA that’s used to justify purchase and leverage multiples. EBITDA is frequently adjusted for cost synergies and for future revenue enhancements and, historically, the level of today’s adjustments is very high. I believe these EBITDA adjustments will be a driver of the differences we see between the default-and-loss scenario of the next cycle and the 2007-10 cycle.

Do you feel that competition has forced mid-market managers to specialise?
I think there are certainly niche strategies that can be effective in this market. But the main way competition has impacted managers is showing the importance of scale. You’re operating in a scenario where there are a handful of scale lenders that lead the market and it forces other managers to either invest in their platform or be relegated to a participant role.

At Varagon, we’ve invested heavily in our people, platform and capabilities. We have nearly $7 billion of assets under management, a one-stop product set and a hold size that we think allows us to compete with anyone. We have over 45 employees and we’ve built an organisation that’s designed to efficiently and effectively screen transactions in order to provide swift feedback to sponsors. Given the multi-industry focus of most sponsors, it’s critical that you have expertise in a range of industries including the specialised underwriting resources for areas such as healthcare. We’re very focused on making sure that we have the resources to compete in a market where scale is a differentiator.

Varagon created the Senior Direct Lending Program with Ares in 2015. What are the benefits of platform partnerships like this and do you think these types of partnerships will become commonplace?
I think you’ll probably always see people forming partnerships, but the part to watch is how many are really successful. And how many deliver a better product to the market, or just allow smaller players to keep up with competitors. SDLP is two scaled platforms coming together to provide hold sizes of over $400 million in unitranche, which is a real differentiator in the market.

As we all know, partnerships are awfully difficult to execute. The ability for joint ventures to be successful is dependent on several factors. I think it’ll be rare to see two market leaders, like us and Ares, coming together and being as successful.

Are there any specific sectors in which you are seeing heightened activity?
In the sponsor finance space, there are natural ebbs and flows within sectors. We continue to see robust activity in our pipeline in a range of areas including business services, software, healthcare, manufacturers and value-added distributors. Across industries, our focus is on strong business models with solid fundamentals and appropriate capital structures.

What macroeconomic factors should direct lenders be concerned about?
We’re constantly thinking about and analysing a host of macroeconomic factors in our underwriting and our portfolio management, including where we are in the economic cycle, rising rates, inflation, and others. We’re also focused on legislative changes and the broader geopolitical climate. You’re seeing a lot of volatility today and, at some point, there will be a downturn. I can’t tell you exactly when or what the trigger will be. But our job as a lender that lends across cycles is to be prudent in an aggressive market and to be prepared for that downturn.